When building an investment portfolio, some of the best advice is to avoid putting all your eggs in one basket. Allocate your assets among several different investments so if one area of the market comes under pressure, one stock fails to perform or the economy takes a turn for the worse, you won't lose a large portion of your principal. The key is diversification of your investments — dividing your total investment funds among different investments that do not move in the same direction under different market conditions.
Simple diversification works this way: If you have $100,000 to invest, divide it into $10,000 increments and invest in 10 different securities. You can allocate those assets among blue-chip stocks, speculative stocks, dividend-paying stocks, mutual funds, exchange-traded funds, bonds and money market investments. You can achieve diversification by buying stocks in different industries or using different ETFs or mutual funds that specialize in certain industrial or geographical sectors. A mutual fund or an ETF is, by the fact that it contains positions in different stocks, a diversified investment vehicle. Some mutual funds and ETFs are specifically designed to provide broad diversification and are appropriate if you have investment funds smaller than approximately $50,000 — not large enough to divide among several different types of investments.
Benefits of Diversification
Market sectors are cyclical. When the economy slows, people stop buying new cars and make home repairs themselves. Automobile stocks and the stocks of companies that produce other consumer durables decline in price, but home improvement stocks and discount retailers rise in price. As the economy recovers, so do the prices of automobile and recreational vehicle stocks because the consumer has more money to spend on luxury items. Consumers also shift away from doing home repairs themselves. If your portfolio is invested in different sectors of the market that move differently in different cycles, price appreciation in the favored sectors will make up for price declines in the out-of-favor sectors. Diversification also protects your portfolio against surprise negative news on one of your investments.
Diversification can also limit your profits if a certain company or sector experiences unusual growth. It also doesn't protect you from broad market declines during periods of extreme financial crisis that bring on long-term bear markets. Owning bonds in your portfolio may partially offset a broad decline in stock prices if the Federal Reserve lowers interest rates, but corporate and municipal bonds can lose money even under these circumstances if their credit qualities come under suspicion. Creating a properly diversified portfolio that protects you from all loss is impossible. It is also difficult to diversify properly because it involves selecting securities that do not move in tandem amid market variable that occasionally result in exactly that result in high correlation of movement between stocks that normally do not correlate. In the crash of 1987, stocks declined in price across the broad market and U.S. Treasury bills and bonds also declined in price because investors sold them to pay for margin calls on their stocks and this triggered further sales of Treasuries to avoid loss. Normally, Treasuries would move higher in price as stocks declined.
The most important thing to remember about diversification as a strategy to protect your investment principal is what is true today may not be true tomorrow in a marketplace that now spans the globe like never before. Investors from other countries react to conditions in their own markets by shifting money to the U.S. An example of this is the strength in U.S. stock markets following the credit crisis of 2008. As economic troubles appeared in other countries, investors moved their money to U.S. securities because they felt the U.S. was a safer place to keep their money. This helped to bring interest rates in bonds to record lows and allowed the Federal Reserve to finance corporate and sector rescue inexpensively. The stock market benefited because many investors avoided the low interest rates in favor of price appreciation potential in an expected recovery of the stock market. To optimize the protection provided by diversification, re-allocate your investment diversification when there is a substantial profit created in one or when external factors such as geopolitical strife or market sectors rotate according to economic change.
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