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Benefits of Diversification
By Sean Condon, CFP®
What if there were a way to hedge the downside risk of the markets while still experiencing much or all the upside? If this worked with 100% certainty, it would be the perfect investment. Unfortunately, investing always involves risk and uncertainty, so no strategy can be perfect. But perfect is also the enemy of good. For long term investors, diversification is about as good as it gets.
Basics of Diversification
Diversification is simply a way to avoid putting all your eggs in one basket. For example, instead of putting all your money into a single stock or cash, your portfolio is invested in a mixture of stocks, bonds, and other commodities, which allows you to minimize risk in volatile markets and still receive high returns across your portfolio.
Why It Can Be A Risk Management Tool
To give you an idea of why this is a proven strategy to protect your portfolio, take a brief look at this visual table. This table includes 8 different asset classes that are represented by 8 different colors and ranks the performance of each one from best to worst over the last 20 years. As you can see, rankings change every single year, which reinforces the fact that there is uncertainty in all capital markets.
By adjusting how much you allocate to different asset classes you can manage overall risk in your portfolio. This doesn’t mean that investing in multiple asset classes means you have no risk at all. It means that some investments will be zigging while others are zagging, and your portfolio overall can be better protected against downturns.
Of course, diversification also means that not every position will perform well in every scenario. It can make you feel foolish. It requires patience through market extremes and can make you wish you hadn’t spread out your investments and managed risk, but instead put all your eggs in the one basket of the market leader.
In the short-term, this fear of missing out can be painful, but over the long-term diversification has historically rewarded investors. For example, following its March 2000 peak, the Nasdaq Index of large U.S. technology companies had a yearly loss of 6.3% over the next 10 years. In this situation, diversified investors who didn’t own 100% technology stocks were able to gain from other asset classes and did not suffer the “lost decade.”
How to Accomplish Diversification
So how do you make sure you have a diversified portfolio and that it stays that way? A key element of portfolio design is the ongoing process of rebalancing. Rebalancing means selling some of your better performing investments and buying a bit of your laggards (“sell high” and “buy low”). The goal is to reestablish your target asset allocation. Here’s an example:
Asset allocation will greatly depend on how close you are to retirement age, but let’s say you want to have 80% allocated to higher-risk asset classes like stocks and 20% in lower-risk asset classes like cash and bonds. However, when stock prices go up, your portfolio allocation is closer to 90% stocks and 10% cash or bonds. In order to minimize risk and get back to your desired asset class allocation of 80/20, you sell stocks at a high and increase the amount you have in cash or bonds to be 20% of your portfolio.
Just like you have routine checkups on your health, you need to regularly rebalance your investment portfolio to ensure the health of your finances.
Is Your Portfolio Diversified?
Diversification and rebalancing are extremely beneficial in maintaining a portfolio that reflects your risk tolerance and will help you achieve your goals. While they are not difficult concepts, the lack of implementation can have a large impact on your financial goals.
We at Windgate Wealth Management can offer you a complimentary consultation to assess your needs, make sure your portfolio is diversified to your risk tolerance and that it remains balanced. You can reach us by calling (844) 377-4963 or emailing firstname.lastname@example.org. You can also book an appointment online here.