What Is Diversification? 8 Ways to Reduce Investment Portfolio Risk
No matter what any professional talking head on TV says in regard to daily stock tips, no one on the planet can accurately predict how markets will behave over a long period of time.
After all, the markets are a product of human invention, and human beings are prone to irrational outbursts and emotional decisions that aren’t always considering one’s best financial interest. Investing is an inherently risky activity, and markets move up and down in ways that are never entirely predictable.
So, what’s an investor to do? The answer’s simple: Diversify your portfolio.
“When reviewing your portfolio, it’s important to consider all investments plus real estate, business ownership and cash value life insurance,” says CERTIFIED FINANCIAL PLANNER™ Professional and USAA advice director Robert Steen.
What Is Diversification?
The easiest way to describe this is through the classic proverb “Don’t put all your eggs in one basket.” Diversification means not putting all your money in a concentrated spot of the market by holding too much stock in a single company or putting too much money in a specific sector, like technology or energy.
To diversify your investment portfolio is to scatter your money across a broad variety of investment types, so if a company goes belly up, or an entire industry has a really bad year, you’re less likely to see the full value of your investment portfolio drop as dramatically as it would if you had put everything into that defunct company or lagging sector.
“Consider your own company’s stock. Would you still hold it even if you didn’t work there?” Steen says.
To understand how diversification works, here are a few examples that could help balance the risk of investing in the markets while reaping some of the long-term rewards.
Variety Is the Key to Diversification
You can mix up your asset classes so you’ve got some of each, including stocks, bonds, funds and cash. Then, within each asset holding, you can mix it up even further.
- Bonds These debt-based investments come in lots of flavors: corporate bonds, municipal bonds, domestic (U.S.) and foreign bonds, short-term bonds, long-term bonds and bonds that have higher or lower ratings (which indicate a higher or lower risk/reward potential).
- Stocks You aren’t limited to just U.S. companies! There are options to choose foreign companies – from more established nations, as well as emerging markets. Pay attention to company size: Smaller firms with big growth potential have a higher risk/reward volatility, whereas larger, more stable businesses may provide more steadiness.
- A bundle of funds. Mutual funds and exchange-traded funds (ETFs) are investments that are already diversified! Each fund has its own mix of stocks, bonds, and/or cash, in varying amounts and types depending on the intent of the fund.
Choosing a mutual fund or ETF doesn’t automatically mean you’re diversified: If the funds chosen are all focused on the tech sector or companies in Europe, you’re still concentrating your risk (aka putting more of your eggs in fewer baskets). Understand the objective of each fund to ensure a wide variety of approaches for true diversification.
“Check the individual holdings within each fund to ensure that you don’t have a significant amount of overlap,” Steen says.
Customize Your Diversification Strategy
Just as no two people are the same, no portfolio mix look identical between individuals. Your portfolio selections must match your risk tolerance, so the calibration fits your appetite for risk. If your portfolio is less risky than your appetite, you may be disappointed with results when markets have a good year. Or, if your portfolio’s risk is well outside your comfort zone, a market downturn might make your stomach churn and cause you to swear off of investing forever — also not great.
“Besides your tolerance for risk, consider your capacity for risk. How much volatility could your investments tolerate, without your being thrown off target for achieving your goals?” Steen asks.
Plus, pay careful attention to the proportions of your investments, as these can (and should) evolve over time. The younger you are, the more time you have to weather the stormy ups and downs of the market, so conventional wisdom suggests having more risky investments (like stocks) during this time. But the older you get, and closer to retirement, you’ll want less risk and volatility to the nest egg you’re about to depend on, so weighing more toward bonds or fixed income makes the most sense.
When in Doubt, Work with a Pro
Today, certain investments, digital platforms, programs and professionals make creating diversified portfolios customized to your goals and situation more accessible than ever. Having the right mix is key, so explore these options and let the professionals do the heavy lifting while educating you along the way.
Want to talk to a USAA professional about diversification? Email email@example.com or call 800-531-USAA (8722) to get your investment portfolio on track.
Investing in securities products involves risk, including possible loss of principal.
This material is for informational purposes only and is subject to change at any time due to market or economic conditions.
Diversification is a technique to help reduce risk. There is no absolute guarantee that diversification will protect against a loss of income.
Exchange-Traded Funds (ETFs) are subject to risks similar to those of stocks. Investment returns may fluctuate and are subject to market volatility, so that an investor’s shares, when redeemed or sold, may be worth more or less than their original cost.
Certified Financial Planner Board of Standards, Inc. owns the certification marks CFP® and CERTIFIED FINANCIAL PLANNER™ in the United States, which it awards to individuals who successfully complete the CFP Board’s initial and ongoing certification requirements.
Financial planning services and financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License # 0E36312), a registered investment adviser and insurance agency and its wholly owned subsidiary, USAA Financial Advisors, Inc., a registered broker dealer.
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