If there’s an idiom that has relevance for investors, it has to be, “Don’t put all your eggs in one basket.” In one short, catchy sentence, a crucial pearl of wisdom is imparted: having a portfolio that is too concentrated is dangerous.
The flip side to this, of course, is that diversification can be a winning long-term strategy. What does this term really mean, though? It’s bandied about often enough that some people may regard it as a bit of a buzzword.
Simply put, diversification is an approach to investing that spreads risk around. If the strategy had an idiom of its own, it might be, “Put your eggs in many different baskets.” That way, should something unfortunate happen to one of the baskets, all won’t be lost.
The different baskets of a diversified portfolio
Spreading risk around is easy to understand, but how does this happen in practice? For most investors, there are a few major investment classes that will comprise most of their portfolio:
- Equities: commonly referred to as stocks, these are shares of companies. Over time, equities are the major asset class that tends to provide much of the capital growth for an investor. On the other hand, they are also more volatile than either fixed-income products or cash. Risk and reward, as the saying goes, are related.
- Fixed Income: this is the part of a portfolio where you’ll find bonds and similar products. They usually don’t fluctuate nearly as much as stocks, but their purpose is more income generation than capital growth. More conservative investors will tend to have a greater part of their portfolio in fixed-income.
- Cash: it’s a good idea to always have some cash as part of overall investments. That way, when markets take large tumbles and compelling opportunities emerge, you have the liquidity to take advantage of them.
Diversification within asset classes
With equities in particular, it’s important to own shares of companies in different sectors. Just owning energy or consumer shares, for example, would be putting all of your stock holdings in essentially one basket. In a similar vein, it’s a good idea to have some geographic diversification as well. If you only hold stocks listed on your home country’s exchange, you may miss out on growth happening around the world. And there’s nothing that says your domestic assets will be an outperformer in any given year.
Why diversify? Let us count the ways
There are a number of benefits to portfolio diversification:
- It reduces overall volatility. By avoiding concentrating your holdings in one or two sectors, you can avoid dramatic ups and downs. When one part of your portfolio falls, another may rise to offset it.
- You can sleep better at night. Imagine having most of your money in one stock or one industry. The volatility of your portfolio’s value would almost certainly cause unneeded stress and worry. With a diversified portfolio, you may not be insulated from market declines, but it’s easier to withstand them psychologically.
- Capital is preserved. One key drawback to a concentrated portfolio is the risk that you might suffer a large permanent loss. Getting back to ‘even’ may then prove to be a daunting task. By contrast, a diversified portfolio helps to prevent the chance that such a serious loss will be incurred.
Leave the concentrated bets to the pros
Every now and then, you might read a book or see an article about a professional investor who put almost all of their eggs in one (metaphorical) basket and reaped massive gains. Keep in mind when you encounter such stories that these people make these bets for a living. Moreover, remember that there are countless untold tales of those who concentrated their portfolios and did not end up ahead. Diversification, while not flashy, is the best approach for most investors with a long-term horizon.
Dixon Advisory, Benefits of Diversification:
Foresters Financial does not provide investment, tax or legal advice. This material has been prepared for informational purposes only. Please consult with your financial advisor before engaging in any transaction.
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