Financial Tip

Financial Tip
Rich Best has spent 28 years in the financial services industry, as an advisor, a managing partner, directors of training and marketing, and now as a consultant to the industry. Rich has written extensively on a broad range of personal finance topics and is published on several top financial sites. Recent books include The American Family Survival Bible and Annuity Facts Revealed: What You MUST Know Before You Invest.

Crash-Proofing Your Retirement Portfolio through Diversification

Crash-Proofing Your Retirement Portfolio through Diversification

As far back as our childhood, we have been told that we should never put all our eggs in one basket because, if the basket breaks, we could lose everything. That old axiom forms the framework of one of the most important tenets of investing – reducing your risk through diversification.

For a more vivid illustration of how diversification reduces risk, imagine you’re trying to get to the top floor of a tall building, and the only way up is to take an elevator. You have a choice of two elevators. The one on your left is supported by one, skinny cable. The one on your right is supported by ten cables. It looks like both elevators are going to be pretty full, so which one do you choose? Of course, you want the one with ten cables!

Now think about how you will be riding your 401(k) plan all the way up to retirement. If you had only one stock in your portfolio, your portfolio would bounce up and down as that stock’s price goes up and down. If that company goes bankrupt, your retirement portfolio comes crashing down. You could add a few more stocks, but would you get on an elevator with just a few cables? You could also add some bonds, which would help because they can act as a counterweight when stocks are performing well. You could stabilize your portfolio even more by adding a few stocks and bonds from outside the U.S. That’s because global markets tend to act differently than the U.S. stock market. While these additions to your portfolio can help to smooth out the bumps, your portfolio still wouldn’t be adequately diversified.

What Exactly is Diversification and How Does it Work?

Diversification is the recognition that it is very difficult to know which market sector or asset will outperform another, and that different sectors or asset classes perform differently from one another. So, instead of trying to guess, diversification allows you to capture the returns wherever and whenever they might occur while keeping the overall volatility of your portfolio low.

When properly done, a diversified portfolio should outperform a more concentrated portfolio over the long-term. The key is to choose non-correlating assets to mix into your portfolio. For example, stocks and bonds are non-correlating assets – when stocks are performing well, bonds tend to underperform. But at least bonds continue to generate a yield when their prices underperform. When stock prices decline, bond prices tend to rise, so they provide a counterweight to declining stock prices. Real estate is also a good hedge against falling stock prices.

The key to building wealth is not through seeking big gains in your portfolio. Instead, it is through minimizing your losses during market declines, which is the purpose of diversification. It used to be that, if you wanted to construct a diversified portfolio of stocks and bonds, you would need a large amount of money – upwards of $1 million – to do so properly. That’s because you would need to purchase a basket of individual stocks and bonds large enough to achieve broad diversification. However, investors can invest any amount of money in a basket of securities through mutual funds.

Mutual Funds and Exchange-Traded Funds Offer Instant Diversification

Mutual funds and exchange-traded funds (ETFs are designed to provide investors instant diversification in any asset or market sector at a low cost. A typical mutual fund invests in dozens of securities targeting a specific investment objective, such as conservative growth, aggressive growth, income, and capital preservation. Through mutual funds, it’s possible to own hundreds of securities with as little as $10,000 invested.

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