“Diversification” is probably one of the first terms you see when you read about strategies for smart investing. But are you clear on exactly what it means to have a diversified portfolio and why you should care?
Diversification Defined
Diversifying your investments simply means making sure all of your money isn’t in just one financial “basket.” Instead of investing in a single security, diversified investors put their money into a variety of different stocks, bonds, mutual funds and exchange-traded funds (ETFs).
The idea is that if one investment goes down in value, the other investments may help to mitigate the loss by remaining unaffected or possibly increase due to the market conditions. In this way, diversification may help you keep your portfolio in balance and still have the possibility of producing a positive return. While a diversified portfolio may not produce the returns of a portfolio with an overconcentration of assets in one or a limited number of investments, one of the many benefits of diversification is that it helps to reduce your risk of losing money during periods of market volatility and/or market declines.
What Kinds of Investments Make Up a Diversified Portfolio?
There are many different ways to diversify your money. The most basic type of diversification is by asset class. For example, your portfolio might feature 70% equities (investments in stocks) and 30% bonds (fixed-income-type investments). The exact diversification approach you use depends on your time horizon—when you’ll need to withdraw your money—and your risk tolerance.
You can also diversify your investments using a mix of other factors:
• Geography: You could invest in both U.S.-based and international funds. Within international funds, you could diversify further by investing in both established financial markets and less-developed countries (known as “emerging markets”).
• Investment style: One mutual fund or ETF might focus on investing in undervalued stocks or funds —a strategy known as value investing. Another fund might invest in companies with a consistently strong earnings record. Owning a mix of funds that adhere to different investment strategies is another way to add diversification to your portfolio.
• Company size: Investors often sort companies into different stock groupings based on their market value. Companies with a very high market value are “large-cap” companies, mid-range companies are “mid-caps”, and lower-valued companies are “small-cap” firms. When you diversify your portfolio by company value, you might invest in a mix of large-, mid-, and small-cap stocks or stock funds.
• Industry sector: Well-diversified investors spread their money over different parts of the economy, such as health care, technology, manufacturing and so on. Why? When one lags, chances are good that another industry is steadily earning.
How do I build a well-diversified portfolio?
Mutual funds and ETFs already have a certain amount of diversification baked into them because they invest in a range of companies, often holding hundreds or thousands of stocks. In addition, these funds clearly lay out their investment strategies—including their diversification priorities—in their prospectuses. Finally, fund names name may offer a clue about their strategy. For instance, a stock fund might be called the Acme Emerging Markets Bond Fund or the Acme Small-Cap Stock Fund.
It can be tough to diversify your portfolio on your own. Some investors diversify too broadly, which can limit their ability to outperform the market. A Financial Advisor can help you optimize your portfolio to achieve the right level of diversification as part of a strategy that is based on your risk tolerance, time horizon and individual goals.
Brian Jacobs is a Executive Director and Wealth Advisor in Valencia, CA at Morgan Stanley Smith Barney LLC (“Morgan Stanley”). He can be reached by email at brian.jacobs@morganstanley.com or by telephone at (661) 290-2022.