Investors: Do not sleep on portfolio diversification | Smart Change: Personal Finance
(Sam Swenson, CFA, CPA)
With stocks in a bear market, bonds offering little more than “less negative” returns, and cryptocurrency facing serious reckoning, the first half of 2022 should remind investors that a diversified portfolio will be essential in the coming years. Overexposure to any particular stock or stock sector can result in crushing portfolio losses, which can have an impact on investment momentum or worse — putting your retirement at risk.
Let’s take a moment to reconsider why diversification is still so important to the success of your investment.
Diversification: a quick review
“Diversifying your portfolio” is another way of saying that you are appropriately spreading your money across several different investments. While it is great to make money through investing, do not lose Money should also be a major consideration. Diversification reduces risk.
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Concentrated stock positions – for example, if you were to keep all your money apple Stocks – tie your financial future to the performance of one company, exposing you to unnecessary risk. Adding more stocks in different industries is more likely to give you a decent return, while also reducing the chance of losing large amounts of money.
Index funds: a simple solution
If you make all-or-nothing bets on stocks or cryptocurrencies, you are likely to be risking a lot more than you realize. This is why broad-based, market-tracking index funds can make so much sense to retail investors.
Index funds track entire indexes, such as Standard & Poor’s 500 or the Contact 2000, which consists of hundreds of companies in various sectors. Total market funds, such as Vanguard Total Stock Market Index Fund ETF (NYSEMKT: VTI)More companies are tracking and can be thought of as many index funds have been merged into one fund.
Fundamental index funds can do wonders for investors by bundling stocks together into easy-to-purchase and easy-to-manage securities. This money also diversifies, so you don’t have to worry if any company – or even a sector – is experiencing poor returns over a certain period of time.
Diversification in 2022
As the chart below shows, the large portfolio in developing stocks (like most technology companies) has underperformed severely in a handful of valuable stocks from the start of this year so far:
An investor who made a big bet on stock growth at the beginning of the year would have reduced his position by about a third, while a value-only investor would have decreased by just over 10%.
The middle line, which represents all the big stocks (value and growth), was no surprise to show an average result. While losing more than 20% of your money isn’t something to be happy about, an S&P 500 investor avoided a much worse outcome by committing to diversification.
This is all to say that putting your money around matters and can help avoid catastrophic outcomes, even if the markets fall broadly. An investor who puts his money into just a few growth stocks could drop much more than 32% – a scenario that could have been taken off the table with proper asset allocation and forward planning.
Re-commit to allocating your assets
To survive in an environment with low expected returns, you will need to recommit to a diversified portfolio by allocating assets sensibly. In other words, consider allocating a percentage of your money to different asset classes and sticking to your plan over time. Too much money in any asset class can spell disaster, especially in a scenario where no one knows what will happen next.
The risk of financial ruin can be reduced through diversification, which can help reduce volatility within your portfolio. Take your time to be deliberate and intentional when it comes to allocating your money. The future will be grateful.
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Sam Swenson, CFA, CPA has positions at the Vanguard Total Stock Market ETF. Motley Fool has positions in and recommends the Apple and Vanguard Total Stock Market ETF. Motley Fool recommends the following options: long March 2023 calls worth $120 on Apple and short March 2023 calls worth $130 on Apple. Motley Fool has a disclosure policy.