Diversification: Your Lifesaver During Stormy Financial Times
If the past two years haven't drawn your attention to the value of a diversified portfolio, then perhaps nothing will. Let’s do a quick review of the concept of diversification so you take advantage of lessons learned during this ongoing financial rollercoaster.
Spread Your Wealth
First, diversification simply means spreading your savings across a variety of investments. A logical place to start is by building a portfolio around a low-cost, highly diversified Total Stock Market Index Fund (e.g., VTSAX).
The VTSAX tracks the performance of virtually 100% of the investable U.S. stock market. Unlike the S&P 500, it includes large-, mid-, small-, and micro-cap stocks. Let that fund be the beating heart of the equities portion of your portfolio. It alone should reduce your risk of investing and might just lead to a higher portfolio yield over the long haul.
Next, consider buying fixed income investments…bonds, for example…which traditionally move in the opposite direction of individual stocks or stock mutual funds in reaction to interest rate changes. Why?
Various types of assets behave differently as a typical economy breathes in and out, offering varying potential for capital gains and losses. Over the long haul, stocks have offered the highest yields but tend to fluctuate more dramatically in the short term (the sawtooth-appearing chaos depicted on a daily chart smooths out over time).
For this reason, the importance of patience plays a bigger role in holding stock or stock funds in one’s portfolio as opposed to bonds…which offer steadier returns in light of their fixed payouts. But remember, prior to maturity, a bond’s value can vary as interest rates rise and fall. We’ve all witnessed the impact of rising rates since early 2022 as the Federal Reserve wages war with inflation. If held to maturity, bonds will return their face value (except for the ravages of inflation). I personally enjoy the benefits of stock mutual funds because they hold a broad array of company shares – unless, of course, a given fund invests more narrowly in a specific kind of company or industry (i.e., energy or healthcare companies).
Get Real (Estate)
Buying real estate (I call ‘em “hard assets”) is another means of diversifying a portfolio. Because real estate can be more complicated and expensive to purchase and maintain – and often appreciates more slowly over time – most families limit their real estate exposure to buying a home. Depending on location and circumstance, they frequently get their cake…a place to live… and eat it, too…appreciation in value.
More adventurous entrepreneurs might acquire assets to rent out, but that involves the additional risk of finding responsible tenants who pay their rent on time – and often requires different degrees of landlord “elbow grease,” for repairing water leaks and broken toilets that often occur at night or on weekends.
Stash Short-Term Savings
Don’t forget those short-term investments in bank CDs, money market and bank savings accounts. Investors often use such stores of cash for rainy day funds and as temporary reservoirs for surplus money after the sale of other investments.
In today’s market, these short-term deposits can earn up to 5% and beyond, unlike recent years when most of them were paying yields close to zero. But for the moment, don’t overlook them as beneficial short-term investment opportunities.
In summary, diversification offers several benefits to the average investor, but at the top of the list, (if handled properly) is the enhancement of one’s potential return over time…along with portfolio stability. Simply stated, owning a variety of quality assets in an everchanging marketplace will tend to reduce the overall risk of your portfolio, reducing the prospect of a single bad choice severely impacting your portfolio.
Variety can indeed be the spice of life.