You've heard it said before, "Don't put all your eggs in one basket." It's wisdom that can be applied in many areas of life, but it's especially important when it comes to investing. A diversified portfolio is one of the best strategies for those hoping to reduce risk.
The basic principles of diversification
The concept is simple. If an investor puts all their money into one stock and that company goes bankrupt, their money is lost. But if they invest in several different stocks and bonds, the overall portfolio is probably not as affected as much by one company going bankrupt or even just performing poorly.
Take WorldCom, a popular company in the 1990s, as an example. WorldCom's stock price surged in the latter part of the decade, growing at an average rate of 45% a year. At the same time, the index fund it was part of, the S&P 500, grew at a rate of around 20% a year.
Based on that, it appeared that investing solely in WorldCom would've been a better choice than a broad index like the S&P 500. But, while an investor would've earned more money with WorldCom during that timeframe, they also took on a much bigger risk. Ultimately, that risk didn't pay off. Due to fraudulent accounting practices, WorldCom went bankrupt in 2002.
If an investor had bought only WorldCom stock, they'd be left with nothing. But if they invested in the S&P 500, their assets would've continued to grow.
Even though WorldCom failed, its bankruptcy didn't cause the entire index to fail. That's diversification in action.
How to diversify well
Diversification goes beyond just picking two different stocks or bonds. To diversify well, an investor needs to consider things like sectors, company size and location.
Sectors are things like utilities, energy, materials, health care and information technology. There are many more, and the expectation is that they wouldn't all experience hardship at the same time.
When building a portfolio, people should avoid putting most of their investments into one sector. Imagine a portfolio made up entirely of oil-related stocks in manufacturing, transportation and distribution. If solar cars ever became the main method of transportation, that portfolio would suffer.
How many Blockbuster stores have you seen lately? They used to be everywhere, but with the invention of Redbox and streaming services, people rarely walk into a movie store on a Friday night.
Spreading investments across a variety of sectors helps reduce risk.
Stocks can also take many forms.
- Common and preferred
- Large, mid and small-cap
- Domestic and international
To reduce risk, it's smart to spread investments across these different forms in case a changing market impacts one form or location more than others.
Pro tip: Mutual funds are a great way to diversify. They often allow people to invest in thousands of companies from different sectors. They usually include companies that are different sizes and from different locations. That way, if one company in a mutual fund fails, the fund as a whole usually doesn't take as big of a hit. Learn more about how mutual funds work by reading this article.
More things to consider
When should I rebalance my portfolio?
It's important to remember that diversification is an ongoing process. That's why it's a good habit to monitor investments regularly.
It could be that one part of an investor's portfolio surges in growth and becomes a much larger percentage of the portfolio than they originally intended. This is great news for their finances. But if they want to continue limiting risk, they should look at rebalancing things.
Or, sometimes employers award their own company's stock as part of a salary or bonus. If an employee isn't paying attention, that stock can quickly become a concentration in their portfolio.
In this case, diversification is very important because if the company fails, the employee could lose not only their job but also a large chunk of their investments.
Rebalancing might mean an investor sells assets in a growing area of their portfolio to reduce concentration. While at the same time, they can buy assets in shrinking areas.
USAA suggests analyzing portfolios once a year and making changes when the target allocation is off by more than 10%.
How do risk tolerance and risk capacity affect diversification?
Risk tolerance refers to how much risk someone can handle.
Maybe an investor thinks they'd like to put a large percentage of their money into a risky stock because they want to take advantage of potential gains. If they end up selling at a loss because they're stressed out, they might have a lower risk tolerance than they thought.
Normally, someone with a higher risk tolerance has a portfolio more heavily weighted in stocks. Someone with a more conservative risk tolerance usually has a portfolio more heavily weighted in bonds and cash. Over time, stocks tend to outperform bonds and cash, but they're riskier.
Risk capacity refers to someone's ability to take on risk.
Just because someone is willing to take on risk doesn't mean they can afford to. Let's say an investor is willing to invest 100% of their portfolio in stocks. If they'll need that money in two years when they retire, they probably don't have the capacity to take on that much risk.
The opposite is also true. A 20-year-old just starting to save for retirement may be naturally risk intolerant. But they have a huge capacity for risk since they won't need their money for another 40 to 45 years. In their case, being too conservative is risky because their portfolio growth might not keep up with inflation.
The goal should be to build a diversified portfolio that reflects both risk tolerance and risk capacity. Learn more about risk tolerance and how to pick it by reading our article devoted to the topic.
Should my investments align to my values?
Thematic, or socially responsible, investing is when people choose groups of investments that match what's important to them. These investments can range from health care access to precious metals to environmentally friendly businesses. There are even space technology investments.
While it's OK to align investments to one's values, it's still wise to make sure that a portfolio isn't overly concentrated in one area.
If someone's passion is pet advocacy and they invest with a company that has preselected pet care stock, they might only have 25 companies that meet the criteria.
Contrast that with a mutual fund composed of thousands of companies. I'm not saying these types of investments are bad. It's just that they may add a lot of concentrated risk.
So, what are the main takeaways? A diversified portfolio can help an investor reduce risk while they grow their wealth. And to diversify well, an investor should spread their money across a variety of different sectors, forms and locations. This helps reduce the negative impact of unstable market conditions and changes in technology.
Ready to diversify?
Explore a range of investing options on USAA Investing Page.