When it comes to investment advice for newbies, you’ve probably heard just how important it is to diversify your investments. But what exactly does it mean to diversify, and how does it help grow your money in the long-term?
We’ll go over the nuts and bolts of investing and share some simple ways to diversify your investments:
What Is Diversification?
In a nutshell, diversification simply means not putting all your eggs in one basket. Diversification refers to investing in a variety of asset classes as well as choosing a mix of investments within each asset class, explains Tara Falcone, CFP® and founder of ReisUp. Historically, diversifying your investments has proved to net you returns while lowering the risks.
Note that diversification is different than asset allocation, which refers to the mix of primary investment baskets, or asset classes, in your portfolio. For example, with asset allocation, you could be 100% invested in stocks, or you could be 50% invested in stocks and 50% in bonds, or some such combination. So the 100% stock portfolio just mentioned is likely not well diversified because it only contains stocks. However, the 50/50 portfolio is diversified because you’re investing in both stocks and bonds.
“Diversifying your investments is important because it’s extremely difficult to know which investments will perform best, especially in the short term,” says Mike Palazzolo, CFP® and founder of the Detroit-based financial planning firm Fintentional. “When you diversify, you spread your investment across many companies around the globe.”
“You always want certain pieces of your portfolio to be in favor no matter what’s going on in the market,” adds Falcone. “This allows the in-favor asset classes to ‘cushion the fall’ when other assets are out of favor.” For example, take a portfolio that contains only stocks. If the stock market drops 20%, your portfolio would lose 20% of its value. But if you were 50/50 invested in stocks and cash, your portfolio would only lose 10% of its value.
Your investment mix depends on two main things: 1) your comfort level with risk and 2) your target date for retirement. So if you are in your 20s or 30s and are comfortable taking on a lot of risk, you may have a more aggressive investment mix, which is usually more stocks (stocks are typically riskier but have a higher rate of return) and less in bonds (they’re less risky but also have a lower rate of return).
Here are some ways you can go about diversifying your investments:
Spread Your Contributions Across Different Asset Classes
Instead of investing just in stocks, create an investment mix of the three different asset classes: stocks, bonds and cash. You can do this yourself and change the mix over time. If in doubt, talk to a financial planner and get some expert advice based on your particular situation and money goals. They can provide strategies and come up with a solid game plan to align with your risk level and target dates.
Invest in Low-Cost Index Funds
Diversifying your investments doesn’t have to be difficult or complicated, explains Palazzolo. Many investment firms offer a family of funds. For example, Vanguard offers a family of funds called LifeStrategy that ranges from 20% to 80% stock exposure. Under the covers, the funds invest in Vanguard Total U.S. Stock Market, Vanguard Total International Stock, Vanguard Total U.S. Bond, and Vanguard Total International Bond index funds. By investing in one of the LifeStrategy funds, you would own shares of over 10,000 stocks and 12,000 bonds.
Invest with a Robo-Advisor
These days there are plenty of options to invest with a robo-advisor. While it sounds very futuristic and high-tech, a robo-advisor is just a way to receive financial advice and portfolio management with very little human interaction.
Using algorithms, robo-advisors give you recommendations regarding which investments to put your money in, based on the information you provide. And because robo-advisor platforms usually offer low-fund exchange-traded funds (ETFs), the fees are typically much lower and offer the same rate of return. This is a good option for those who are just starting out or don’t have a lot of money to invest with.
On the other hand, because a robo-advisor is a hands-off option, if you have a unique situation or just want deeper interaction with a professional, then a robo-advisor may not be the best route for you.
Be Mindful of Fees
Of course, if you’re going to make money, you’ll have to spend some money in the form of fees. If you’re investing in mutual funds, index funds, and ETFs, you’ll be charged an expense ratio, which is a percentage of your investment. Expense ratios are charged as an annual fee.
Besides annual fees, you may be charged with transaction fees, management fees and something called a front-end load fee, which is something you pay when you purchase shares of a mutual fund. Like an expense ratio, the fee is also a percentage of a fund. There’s also a back-end load fee, which is something you pay when you sell a mutual fund. This is also expressed as a percentage of the amount you sell.
It’s important to do your research and know what the fees are before you invest. The lower the fees, the more you’ll have to invest. While these fees are normally deducted from your investment so you may not notice them, they do lower the investment amount. As a result, less money will be invested.
The Pitfalls of Diversifying
Note that diversifying could also weaken your portfolio’s overall growth, explains Falcone. For example, if your portfolio is 100% stocks and the stock market goes up 20%, your entire portfolio would be up 20%. If you had $1,000 to begin with, you’d make $200, or a 20% increase. However, if you were 50/50 stocks and cash and stocks rise 20%, but the cash remains unchanged, you’d only earn $100, or 10% overall. Despite that, it will help lower the risk and help you grow your money.
While your money may not grow as much if you invested in individual stocks, diversification will help you spread your risk and help you hit your money goals for the long term. “The best investors aren’t the biggest risk takers,” says Phillip Washington Jr., CFP® and founder of Stone Hill Wealth Management. “They are the most self aware investors who play with the cards they were given, and don’t take risks with their hard-earned money that they don’t understand.”
Do you have a diverse portfolio? Do you manage it yourself or work with a professional? Let us know in the comments below!
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