This story originally appeared on The Penny Hoarder.
You know it’s a bad idea to pour your life’s savings into a single investment.
It’s personal finance 101: Invest regularly, and diversify your portfolio. But a lot of times, there isn’t much guidance beyond that.
So as an investor, you’re left wondering: How do you know if your portfolio is diversified? How many investments do you need in a diversified portfolio? How are you supposed to find the time and money for so many investments, especially if you’re a beginning investor?
There are two things you need to know about diversifying your investments:
One, it’s ridiculously difficult, if not impossible, for ordinary investors like you and me to build a diversified portfolio from scratch.
Two, it’s easy for ordinary investors to own a diversified portfolio if you’re willing to take a few shortcuts. Stick around and we’ll discuss those.
The Goal of Diversification
Diversification isn’t just about picking a bunch of great companies to buy stock in. What happens when the stock market crashes?
“If the stock market drops, you wouldn’t want your entire portfolio to drop along with it,” said Taylor Jessee, a certified financial planner and CPA who is director of financial planning at Taylor Hoffman Wealth Management in Richmond, Virginia. “The idea behind diversifying is to play defense.”
But the goal goes beyond risk management.
“In a general sense, it’s about spreading your risks around,” said Jacob Sadler, CFP with Woodstone Financial in Asheville, North Carolina. “Of equal importance, however, is positioning yourself to capture opportunity when and where it occurs.”
In other words, diversification also helps you seize higher returns.
What a Diversified Portfolio Really Looks Like
Your investment portfolio needs a mix of stocks and bonds. Investing in stocks is where you’ll get the big growth, but it’s also high-risk. Investing in bonds has less earning potential, but bonds add stability to offset stock market risks.
Your ideal asset allocation, e.g., how much of your portfolio is invested in stocks versus bonds, depends on your age, how much time you have until retirement and your risk tolerance.
Sounds simple so far? We’re just getting started. To have a diverse portfolio, you’d need the following.
Stocks in Companies of All Different Sizes
Stock in small companies tends to have the biggest potential for profits, which is why it’s often called growth stock. But growth stock is also risky. Investing in giant corporations offers slow and steady returns but less potential growth.
Government and Corporate Bonds
Government bonds are among the safest investments, but they still have risk. The interest they pay is so low that your investment might not keep up with inflation. Corporate bonds pay significantly higher interest rates, but you could lose the money you invested if the corporation defaults on its debt.
International Stocks and Bonds
Spreading out your investments geographically reduces your risk and also allows you to take advantage of growing markets throughout the world.
A Broad Range of Sectors
Investing in a variety of sectors of the economy — like health care, financial products, real estate and utilities — reduces your risk in case one part of the economy collapses. For example, you’re better protected from a housing bubble collapse or a global pandemic that brings travel and hospitality to a standstill.
Investments That Don’t Move With the Stock Market
To achieve diversification, you don’t want all your investments to rise and fall with the stock market. That’s why you want investments that are stable even when the stock market is volatile — and some that increase in value when the market tanks.
For example, sales at discount stores often rise during recessions and their share prices often increase altogether.
Many investors diversify by going outside the stock and bond markets by buying different asset classes. They might invest in commodities like gold, which usually increase in value during downturns. Or they invest in real estate, which is usually less volatile than investing in stocks.
Now, let’s get to what we promised you: an easy way to build a diversified portfolio that doesn’t require a doctorate in economics. Here’s how to diversify in the simplest way possible.
1. Invest in an ETF That Tracks the Stock Market
The great thing about both exchange-traded funds (ETFs) and mutual funds is that they let you invest in hundreds or even thousands of companies with a single purchase.
The majority of ETFs and some mutual funds are index funds. That means instead of having humans actively managing the investments, the fund is designed to reflect the makeup of a market index, like the S&P 500, which is itself diversified.
“You don’t necessarily need to own a lot of ETFs or funds to be diversified,” Jessee said. “Owning just one S&P 500 index fund means you have your money invested in the 500 largest companies in the U.S.”
You can go even broader than an S&P fund by buying an index fund that tracks the overall stock market. These are known as total market funds.
Pro tip: ETFs tend to have lower fees than mutual funds because they aren’t actively managed.
2. Add in a Broad Market Bond Fund
Investing in a broad market bond index fund gives you broad exposure to the entire bond market in the same way that a total market fund lets you invest in the entire stock market.
The tricky part is deciding how much to put in the stock fund versus how much to invest in the bond fund. You typically want to invest mostly in stocks when you’re young. Then, you allocate more toward bonds when you can’t afford as much risk. Reviewing your asset allocation once a year with a financial pro is well worth the cost.
3. Follow the 5% Rule for Individual Investments
It’s actually OK to have a large chunk of your assets in a single fund, provided that the fund is sufficiently diversified. It’s also fine to invest in individual stocks when you’re diversifying — but caution is required.
“For diversification, avoid investing more than 5% of your assets in any one firm, such as your company’s stock, and 20% in any particular industry because unforeseen events can quickly destroy values,” said Jeffrey Barnett, founder, president and chief investment officer at Fintegrity in Tenafly, New Jersey. “However, it is fine to have concentrated holdings of a fund that owns a portfolio of 50 or more securities.”
4. Use Sector Funds to Invest in Specific Industries
The key to diversifying your portfolio is to be invested in the overall stock and bond markets. But if you want to invest in a certain type of company, like biotech or telecommunications, consider investing in a sector fund that focuses on that industry.
You’ll get greater diversity than you’d get by picking individual stocks in the same industry. Just be careful not to invest too much in a single sector.
5. Don’t Assume More Is Better
Many investors mistakenly think investing in more funds helps them diversify.
“We see this frequently with investors’ investment selections in their 401(k)s,” said Betty Wang, a Denver-based CFP who is founder and president of BW Financial Planning. “The investor is overwhelmed by the many choices of their 401(k) plan so she decides to contribute 5% to each fund offered.”
But a lot of these funds have the same underlying investments, meaning you aren’t getting more diversification. You can often achieve your goals with a single fund or two.
“Overall portfolio performance is unrelated to the number of funds in a portfolio,” Sadler said. “What matters is the number of underlying stock and bond holdings, their weighting and their characteristics.”
6. Automate Your Investments
There’s a way to make portfolio diversification even more brainless, which is to automate things.
One way is by investing in a target-date fund. “[It] automatically invests and diversifies your money according to your age and when you want to retire,” Jessee said. “It is basically a one-stop-shop fund.”
Most 401(k) plans offer these as an option, though you can also invest in one on your own.
If you have a Roth or traditional IRA or a taxable brokerage account, you can automatically diversify by using a robo-adviser. A computer algorithm will create a custom mix of assets based on your age, goals and how much risk you’re willing to take.
7. Try to Pick a Winning Team, Not an MVP
For investors who dream about picking the winning penny stock that becomes the next Apple or Microsoft, diversification may seem like a boring strategy.
But don’t think of investing as trying to pick the person who becomes MVP. Wang suggests treating your portfolio like a team of players, each of whom has different strengths and weaknesses.
“If one player is having a bad game, the other players can carry the team for a win,” she said. “The more diverse your players are, the more likely your team can be successful in various scenarios where different strengths are needed to win.”
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