Diversification is a key concept in successful investing, especially for retirement. This article will help you understand what diversification means, why diversification is important for you and your family, and how you can easily create the needed diversification in your investment portfolio.
Definition:
Diversification refers to spreading your investments around among a variety of both asset classes (stocks, bonds, real estate) and individual investments within those asset classes.
Why:
Diversification is significant because if you are not careful, you can end up with a bunch of different investments that all move in the same direction at the same time with the same result you'd get from just one, more easily managed investment.
How:
Invest in funds
By investing in mutual funds or exchange traded funds (ETFs), you get the benefit of diversification at the level of individual investments, but you may not be getting diversification at the level of asset classes. A "small cap growth fund", which invests in smaller growth companies with a bias for technology stocks, for instance, may have dozens of stocks in it, but most will be similar companies that face similar risks and will react in much the same way to changes in the economy or to competition.
Invest in multiple funds
In order to improve your diversification, invest in multiple funds, not just one. Don't invest in five small cap growth funds, spread your money among several funds with different strategies.
Invest in Stock funds and Bond funds
To maximize diversification, be sure to invest both Stock funds and Bond funds. Over the long haul, Stock funds typically generate higher returns, but they also swing up and down much more. Bond funds are not only more stable, but will sometimes rise in value when the economy goes into recession-at the same time stocks are falling. When the economy strengthens and stocks rise, the bond funds may show lower returns as their value falls in the face of higher interest rates.
Show caution with Individual Stocks
Owning individual stocks directly rather than through mutual funds can be fun-if you like that sort of thing. Generally speaking, individual investors will do less well picking their own stocks than professional fund managers or the stock market, in general. If you want to own some stocks directly, limit those investments to a small portion of your total portfolio. Don't trade too often. Buy and hold the investments for a long time. To achieve optimal diversification in your stock portfolio, try to own at least twelve different stocks from different sectors or industries.
Skip bonds and buy funds that buy bonds
Owning bonds directly imposes a management burden and logistical problems that most individual investors are better off avoiding. Unlike stocks which can last forever, bonds mature, that is they get paid off. Then you have to reinvest the money, requiring you to do a whole new round of research. As with stocks, you'd want to be diversified, forcing you to be constantly monitoring your bond portfolio. Buy two or three bond funds with different strategies to achieve your bond diversification and simplify the work you're required to do.
Use the allocation of stocks and bonds to adjust the risk and return in your portfolio
The more stocks you own, the riskier your portfolio and the higher your returns are likely to be over the long haul. For all but the most aggressive investors, having some bond fund investments helps to balance the risk to allow you to achieve more consistent, albeit, more modest returns over time. As you age, you may wish to slowly shift the balance toward bonds. Most advisors now recommend keeping stock investments (usually through mutual funds) as a key part of your retirement savings even after you retire. With people living past 100 years old, you need your money to last a long time. That means you need dependable, consistent returns, which you can only get with a combination of stocks and bonds.
Investing for retirement can be challenging, but by spending just a little time learning, you can master important but basic concepts that will help you protect your portfolio from risk you aren't being paid to take.
