Diversification is in the running for one of the most-used words when describing any type of investment strategy. It bears huge importance not only to a portfolio, but also to our daily lives. But what do we really mean when we discuss the importance of diversification? And why, after all this time, should we still worry about it today?
Diversity defined is the condition of having or being composed of differing elements (https://www.merriam-webster.com/dictionary/diversity). While this can sometimes sound more complicated, we’re here to explain why having just enough of it is a good thing – and not just an old investing adage repeated over and over. The words “don’t put all your eggs in one basket” may sound commonsense to all of us by now, but it’s important to remember this doesn’t exactly mean picking 25 differing investments and being able to beat the market. Successful fund managers, financial advisors, and retail investors alike often take a broader approach to achieving their best returns by diversifying across asset classes and determining the percentage in each asset class. These are the levels to keep in touch with and assess your comfort level in as time goes on. The most common asset classes include stocks, bonds, real estate, commodities, and fixed income. Each of these classes has sub-classes that allow even further diversification – that all-important investment buzzword again.
A great (and shareable to your millennial relatives or friends) example of why diversification is so crucial comes from the minds over at Ellevest.com. They use the case of investing in a shoe company. If one was to invest all of their money into a company that made rain boots, they tell us, the more it rains, the more you’d make! But on the year it doesn’t rain, you would be in trouble. The same case is made if you were to invest in a company that only made sandals. Investing in both clearly mitigates some of the weather related risk and creates an opportunity to benefit in any climate. Owning different types of assets in your portfolio better protects you against risks that could hit any single one of them.
“I’ve heard of stocks and bonds – what else is out there?” – is something you may be thinking when reading the latest headlines or opening the Wall Street Journal. This is where investments other than the traditional ones come into your portfolio. Alternative assets come in differing shapes and sizes (mainly liquidity and returns), but add the massive benefit of hedging against inflation, as well as having low correlation to the markets, unlike the rest of your portfolio. A successful alternative investment addition to your portfolio is largely dependent on selecting a qualified, experienced investment manager or company. Because of the broad range of options in this space, and less transparency, it is important to ask questions. Reuters recommends considering these five – which apply to both alternative and most other asset classes before investing.
- Do I understand what the fund does?
- Do I trust the fund’s managers?
- What’s the cost?
- What can I reasonably expect them to return?
- How do they fit in my portfolio?
One professional who can help you with these is your financial advisor – often, they are recommending products they have heavily researched, met with the sponsor company’s representatives and examined beforehand. These options most likely correlate with a larger investment strategy, based on your risk tolerance and timeline, and again, should be monitored closely as many things can happen in your life as time goes on. These allocations in your portfolio can always be adjusted, and it’s up to both investor and advisor to remain informed and check-in on everyone’s comfort level.
And that brings up one of the most important things to keep in mind when looking at a diversified portfolio. It takes time to work – focusing on asset classes in general, a lot can happen in both your personal life and in the world while different sectors perform or under perform. This is perhaps one of the most difficult concepts for young investors in particular to grasp, as market news takes greater and greater presence across the front pages of the newspaper and trending topics online. It is great to see millennials (as one myself) step into the forefront of the financial exchange, especially with many new digital products making it easier to get started. But it does make it all the more important to pass along the age-old wisdom and core portfolio concepts to ensure they doesn’t get lost in the increasing volume (and dare I say, growing diversity) of financial buzzwords at our fingertips.
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Presented by Nicolette Davicino