By Brad Wright, CFP
Diversification is an investment concept that could accelerate your path to financial independence. It’s the process of allocating capital in a way that reduces your exposure to any one particular asset or risk by investing in a variety of assets. Simply put, diversification means not putting all your eggs in one basket, but instead placing fewer eggs into many baskets. If the eggs in one basket spoil, you don’t lose your entire portfolio. Diversification doesn’t necessarily mean higher returns on your investments, but it could mean a smoother, less volatile ride that may help you endure market contractions more easily.
These days many investors seem to want to compare their investment returns to the Standards and Poor (S&P 500 Index), which measures the performance of 500 large U.S. companies listed on the stock exchanges. The problem with comparing yourself to the S&P is that it’s not fully diversified. The index is tracking only large cap companies (one basket of eggs). If you’re only invested in large cap companies, your investments will move up and down in tandem with the large companies. There are also mid-cap companies, small-cap companies, and various international companies that the S&P does not consider.
To diversify your portfolio, you would include various sectors on both the equity, or stock side (where you own part of a company’s profits) and the fixed income or bond side (where you own a portion of a company’s debt). Fixed income sectors include bonds or bond funds/ETFs that vary in credit quality and duration (length of time until the bond matures).
During the December 2007 to June 2009 financial crisis, the S&P plummeted 35.26%, whereas a 60/40 somewhat diversified portfolio (fewer eggs in more baskets), meaning 60% in S&P stocks and 40% in 10-year Treasury bonds fell 15.72%. Would you have remained invested if your portfolio was down 35%? It would be tough, especially if you thought the market was going to fall further. Could you have stomached a drop of 15%? Perhaps that would have been too much for you also, but when compared to the overall market declining more than twice that of your portfolio, you may have had a better chance of sticking it out.
Missing even a handful of the best investing days could severely hinder your long-term returns. If you had sold your investments at any point along the market downturn, would you have known when to get back in? Would you have had the courage to do so? Market timing is extremely difficult, and nobody seems able to do it consistently well over a long period of time. There are investors who sold out of the market during the 2007-2009 downturn who have yet to return. The market has more than made up for its losses, and those who have remained in cash, on the sidelines, have sorely missed out on its rebound. As famed investor Peter Lynch said, “The only problem with market timing is getting the timing right.”
Is 60/40 the correct allocation for you? It could be, but you should either assess your investment risk tolerance or better yet, have it assessed by a Certified Financial Planner™ professional (CFP®) first. You may find out you’re more, or less risk adverse than a 60/40 portfolio will provide. Your stomach needs to be able to absorb the down-market days too. If you feel the urge to shift everything to cash at the first sign of bad news, you may want to consider lowering your overall risk. The goal is to remain invested for the long-term.
At the other end of the continuum, there are investors looking to take on more risk. Recently, questions about cryptocurrencies, and how they work into portfolios have come up. Ironically, the only question people seem to be asking is “How do I buy (fill in the blank)?” Nobody is asking “Should I buy it?” or “What are the risks?”
The reality is that there are indeed risks. This asset class is new and volatile. Will it be regulated and if so, how? The U.S. Securities and Exchange Commission (SEC) has yet to approve any crypto ETFs even though they’ve been asked to for years. Can this asset class be part of your diversified portfolio? It can. What we tell clients is to take care of their basics first. Much like using your salary to pay your rent and buy food and clothes before you go out on the town and splurge, make sure you’ve assessed your risk tolerance and have invested accordingly in a diversified portfolio.
Beyond that, we wouldn’t recommend any more than 2%-5% total in ‘speculative investments’ which could include crypto, or any other currencies, art, or in some cases real estate. You need to be ok with the possibility that you may lose your entire investment. Also, to this point, most advisors cannot buy crypto for clients.
Properly assessing your risk tolerance and investing in an appropriate, long-term, diversified portfolio is more likely to help keep you invested and could lead you to financial independence, but remember, it is a slow and steady process, not a get-rich-quick scheme.
Enjoy collecting your eggs.
About the author: Brad Wright, CFP®
Brad Wright, CFP® is co-founder of Launch Financial Planning, LLC, a fee-only firm located in Andover, MA. He is a frequent contributor to WCVB-TV and Mix 104-1 Radio. Brad is Chair of the Financial Planning Association of Massachusetts. Learn more about Brad at www.LaunchFP.com
The opinions penned here are for general information only and not intended to provide specific advice or recommendations for any individual.
The foregoing information has been obtained from sources considered to be reliable, but we do not guarantee that it is accurate or complete. Any opinions are those of Brad Wright.
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