What’s Diversification and Why Should I Care?
Getting smarter about investing means learning some new terminology. One key tenet I teach my clients is diversification. In essence, spreading your investments across industries, countries, different types of securities and account types. This way, if one particular industry or type of security isn’t doing well, hopefully the others will be doing better. You may hear the term “asset class.” The more asset classes you own, the more diversified you will be. There are lots of different asset classes between stocks and bonds.
Here’s a short and sweet diagram of many ways you incorporate different asset classes to improve diversification. See the Investing Glossary to learn more about these asset classes. Note: I’ve added tax treatment, not because it’s an asset class, but because it’s another smart way to diversify your holdings.
Ways to Diversify Your Portfolio
SOURCE: North Financial Advisors LLC
Over time, different asset classes rotate getting the highest returns from year to year. Here’s an example of what that looks like (source: Morningstar).
Asset Class Winners & Losers During Recent 20-year Period
Given the fact that asset class “winners” are always changing and it’s really hard to consistently “buy the bottom” or “pick the winners” — you need a little bit of everything. When you do, you can see you have more consistent returns as shown by the gray “diversified portfolio” in the chart above. Let’s dive into more details about how you should diversify your investments.
Don’t invest everything in one company or stock
To avoid unnecessary risks you shouldn’t invest more than 1-3% of your portfolio in one stock. What happens if that company suddenly has a major PR blunder or tanks a new product launch? Your wealth will start to tank with it.
This gets complicated, especially for people who are offered stock options and or company stock purchase programs. It seems like a great deal because you’re getting a huge break on the initial purchase price. Free money, right?
You’d be in dangerous territory though, because not only are you relying on the company for your paycheck, now a significant chunk of your own accumulated wealth is dependent upon their success or failure. That’s not diversification; that’s increasing the risk that you’ll lose wealth.
There’s a second danger at play: Our own familiarity (or overconfidence) bias. Since we work there, we feel like we know the company better than other investors off the street. This might compel us to buy more thinking we know the trajectory of the stock price. Again this is dangerous thinking. Even if there’s a company culture around owning stock, it’s still very risky.
It’s okay to take advantage of company stock options or employee stock purchase programs, but you’ll need to diversify your portfolio to offset this risk. One technique would be to invest your other accounts (retirement, brokerage, etc.) much more conservatively and in industries not related to your company. How much more conservatively? It depends on your own personal risk tolerance. You can also limit your stock or options purchases, or cycle out of the investments as they mature and put them into properly diversified accounts.
Likewise, if you’re an entrepreneur, it can also be tempting to put all of your available capital into your business. This, too, goes against the principles of diversification. While it may seem like there is no other way to make your business work — you could be risking all of your own wealth. Before you liquidate your assets, including retirement to fund your business, think hard about how to become financially ready to start a business and consider building up a credit profile first.
Invest in More Than One Type of Stock Fund
Once you understand that you shouldn’t own just one or two stocks, you’ve made some progress. Maybe you’ve even done some smart investing in mutual funds that give you access to hundreds if not thousands of individual ticket symbols. Perfect! You’re moving toward more diversification. But you’re probably still not diversified enough. You need to make sure you’re invested in a mix of different-sized companies and types of stock. For example some small-cap, mid-cap and large-cap stocks as well as growth, value and income stocks. See the Investing Glossary for more information about these types of funds.
Mutual funds and Index ETFs are usually pretty diversified and their prospectuses offer information about the type of diversification/style. But there are lots of styles and types of stocks, and there are bonds too. You need all of these in order to be truly diversified. If you only buy a fund based on S&P 500, for instance, you’ll be very diversified with large cap value and growth stocks, but you’ll be missing out on small and mid-cap opportunities, international stock growth as well as the income and less volatile returns from bonds.
Don’t Forget International Holdings
A lot of us feel really comfortable with U.S. based companies. We live here and we’re familiar with the brands. But investing only in American companies hinders us from being properly diversified in the world economy. All countries have periods of high growth and then low growth. Just like what we see in stocks in an industry or sector, one year a certain set of countries will do well while others might do poorly.
Rather than trying to monitor carefully to try and pick the winners before anyone else can, it’s better to diversify your holdings so you have a little bit of everything. You want some non-U.S. stocks including those from developed and emerging economies.
Buy Bonds as Well As Stocks
In general, you buy more bonds the older you get. Your individual asset allocation (mix of stocks and bonds) depends on your risk profile and time horizon. However, even if you’re very young, you can benefit from having some bonds in your portfolio. Adding bonds to an asset allocation reduces the risk and volatility (ups and downs) of your portfolio without decreasing returns too much.
Bonds are a way for companies and governments to raise money. An investor provides funds up front, and the bond issuer will pay coupon payments (interest) to the investor for a period of time until the bond matures, at which time the issuer will repay the original capital. When you buy a bond, the coupon rate (interest rate) is locked in and you’ll be guaranteed your original investment. There’s also a definitive time period until maturity, which is helpful because you can match your investment to your time horizon with short-term, mid-term, and long-term bonds.
However, if you sell the bond before maturity, you could lose or gain part of your original investment depending on current interest rates. When interest rates increase, bond prices decrease and vice versa. Prices fluctuate depending on the economy, and a real benefit to balancing your portfolio with bonds is that the price tends to change to a very different degree than stocks.
If you own both stocks and bonds, on days (or months/years) when the stock market isn’t doing well, bonds may do much better and vice versa. You can see from the Morningstar chart above that in some years, normally low-returning government bonds returned more than stock funds.
Diversifying From a Tax Perspective
You should also diversify from a tax perspective, using a mix of accounts so that when you retire you have more control over where your income comes from and what tax rate you’ll pay.
For instance, a ROTH IRA or ROTH 401k can be useful in retirement because you already paid taxes on the contributions. During your career, the capital gains and dividends kept growing and compounding tax-free. When you’re ready to retire you don’t have to pay taxes when you take your money out. This can come in handy when you need extra cash during retirement for something but would rather not bump up your income into a higher tax bracket. The younger you are, the more benefit you’ll get out of investing using a ROTH IRA or ROTH 401k.
A regular IRA and/or your regular 401k contributions will be treated differently. You got a tax break when you put the funds into the account. During your career the capital gains and dividends kept your wealth growing tax-free. However, when you retire (possibly at a much lower tax rate), you will pay income taxes on the amount of money you take out. Ordinary income taxes are higher than dividend and capital gains taxes. But since you’ll be retired when you take the money out, you’ll be able to control your tax rate by taking out only what you need during the year for living expenses.
For a regular brokerage account you don’t get tax breaks when you contribute or when you take out. However, you don’t have to pay taxes until you earn income or sell an investment, which is also a huge benefit. This type of account can be used for early retirement (because retirement accounts can’t be accessed until you’re at least 59 ½.) You can also control the tax rate you pay by limiting income earned (through dividends and bond interest) and by limiting the selling of investments in your account. Having some of all these types of accounts is extremely beneficial to tax diversification.
When was the last time you reviewed your investments? Do you think you have enough diversification in your portfolio?
If you found this post helpful, please Like, Tweet and share!
Cady North, CFP® is the founder of North Financial Advisors. Her mission is to provide effective and affordable financial planning tools to women who desire to be their best self — financially, professionally, and personally. She enjoys helping clients dream big and find their own financial freedom. Connect with her at northfinancialadvisors.com, or on Twitter @cadynorth.