Diversification: the Key to Successful Investing
Market swings often prompt investors to reassess their portfolios. As you evaluate the efficacy of your investments considering your financial goals, it’s important to revisit two key principles—asset allocation and diversification. Any long-term investment plan will most likely have to weather market ups and downs. Balancing your portfolio to account for a comfortable risk level is important to the overall success of your financial strategies.
Asset Allocation & Risk Tolerance
The main objective of asset allocation is to match the investment characteristics of the various asset categories (equities, bonds, cash, etc.,) to the most important aspects of your personal investment profile—your risk tolerance, your return and liquidity needs, and your time horizon. Based on your investment profile, the allocation of your assets may vary. For example, a more aggressive investor may be interested in growing their assets and be more heavily invested in equities. Alternatively, a more conservative investor who is interested in protecting their assets, may have more of their investment in bonds or money market funds.
You may be unaware of the extent to which your investments are (or are not) consistent with your objectives. Asset categories generally react differently to economic fluctuations. For example, an article about an upcoming recession might force people to tighten their reins around spending, especially in regard to buying luxury items or going outside to eat. However, countercyclical industries, like groceries, utilities, and healthcare would shine. The flip side? If the economy is booming, these countercyclical industries won’t perform as well.
Combining different asset classes can help reduce risk and improve a portfolio’s overall return. While there is no set formula for asset allocation, guidelines can help you accomplish certain goals (for example, the need for growth to offset the erosion of purchasing power caused by inflation).
Remember that market risk is always present. It comes in all forms: accounting risk, business risk, government risk, default risk, financial risk, interest rate risk; and geographic risk.
Diversification
Diversification is an investment strategy used to manage risk for your overall portfolio, using techniques such as mixing your holdings to include a variety of stocks (small-cap, mid-cap, and large-cap), mutual funds, international investments, bonds (short- and long-term), and cash. By varying your investments, diversification attempts to minimize the effects a decline in a single holding may have on your entire portfolio.
Distributing your assets among different investments in different categories can help protect your investments from extreme volatility in the market. For example, if you own several Boeing (BA) shares, you may have felt the volatility in early January, where news of a Boeing 737’s window and door blowing out mid-flight caused their share price to plummet by 8%. In comparison, if you had holdings across several aircraft companies (i.e., Airbus, Lockheed Martin, Northrop Grumman, and Boeing), you would be more hedged against that drop in value. Holding a combination smooths the whole experience out.
You can further diversify your portfolio by investing not only in a variety of company stocks, but also in different vehicles, such as bonds and money market accounts. By doing so, you may reduce the risk of financial losses brought on by a downturn in one area. However, keep in mind that diversifying your portfolio does not guarantee you will receive a higher rate of return on any of your investments – the goal is to smooth out the ride by making your portfolio more efficient on a risk-adjusted basis.
The cornerstone of diversification is a mixture of investments, each of which has broadly differing drivers of strength and weakness. That way, strengths in one investment can potentially offset weaknesses in another at any given time. The less correlated the patterns of two investments are, the bigger the potential benefit from diversification. Alternative investments, such as real estate and precious metals, have historically provided a non-correlated counterbalance in portfolios to traditional holdings, such as stocks.
Over the past decade, some investments that once differed significantly began performing more alike—this, combined with the trend of persistently low general volatility and the rise of passive investing, reduced their potential to offset each other’s ups and downs in your portfolio. As financial instruments and global markets became increasingly liquid and accessible, different asset classes became more closely correlated.
Diversification is not complex; the core idea is to maximize potential returns while mitigating the amount of risk that goes into it. Here is a supplementary document from our partners at BlackRock about the benefits of diversification:
If you have questions about diversification, reach out to schedule a consultation. We can help figure out a plan that fits your goals and can help you build a solid financial future.
Emerald Advisors, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.
