We’re not big on industry jargon here at PrairieView, but there’s one word we want all our clients to know: diversification.
When people say that you “shouldn’t put all your eggs in one basket,” the idea is that if you drop your basket, all your eggs are probably getting cracked.
In finance, we call spreading out your “eggs,” (i.e., investments) across several baskets diversification. If one investment suddenly loses value, you still have your others to balance out the loss. And you can still have that omelet for breakfast, too.
Related: Click here to listen to “Retirement Readiness” episode 38, “Building a Diversified Investment Portfolio”
In today’s blog, we’re exploring what diversification is, why it’s important, and how you can get started (without any more egg analogies – promise).
What is Diversification?
At its core, diversification is a strategy you can use to protect your wealth by spreading your investments out to reduce risk.
The financial market can be unpredictable, with different industries experiencing ups and downs at various times. Even the most successful companies, like Apple or Nike, have their bad days. Likewise, different types of investments also go through cycles of success.
By having investments in various asset classes (like stocks, bonds, real estate, and even cash) and different industries (like technology, healthcare, and consumer staples), you mitigate the impact of these fluctuations. If one area takes a hit, others might hold steady or even experience growth, potentially offsetting any losses.
Why is Diversification Important for Your Portfolio?
While diversification doesn’t eliminate all risk, it does offer an important layer of protection. For example, a recent Morningstar report studied the 2022 market downturn to compare how well-diversified versus non-diversified portfolios held up. They found that diversified portfolios lost 14% of their value as opposed to 17% from the control portfolio.
It’s also important to remember that no one can predict the future. Think of the sudden rush for face masks during the COVID-19 pandemic – a product many of had never thought to purchase –or the suddenly cheap airline tickets available. Many smaller-scale events occur each day that determine the value of investment options.
How Can You Diversify?
Now that you understand the importance of diversification, let’s explore how you can put it into practice.
Diversifying Your Stock Portfolio
Rather than investing in a single stock, it’s important that you choose a variety of stock types so that your portfolio isn’t overly reliant on the performance of any single company. There are two ways you can approach this:
- Invest in different company sizes. Don’t focus solely on established, well-known corporations. It’s tempting to choose stocks of companies you already know and love, but it’s worth it to research other, lesser-known stocks as well.
Consider diversifying across large-cap, mid-cap (medium-sized companies), and small-cap stocks (smaller companies with high growth potential). Each size category carries different risk and reward profiles, offering a well-rounded portfolio exposure.
You can find key information about stocks from:
- Company websites
- Financial news websites like Google Finance or Yahoo Finance
- Investment websites like Investopedia
Of course, if you want personalized advice tailored to your unique goals, it’s best to connect directly with your financial advisor!
- Invest across different sectors. In most cases, you don’t want to limit yourself to a single industry, like technology or healthcare. Spread your investments across various sectors, such as consumer staples, financials, industrials, and utilities. This way, if a certain industry takes a hit and your stocks lose value, you’ll have others in your portfolio to balance them out.
Mixing Stocks and Bonds
While diversifying within the stock market is crucial, incorporating bonds into your portfolio adds another layer of protection.
Stocks represent ownership in companies, and their value fluctuates with the company’s performance and market conditions. Bonds, on the other hand, are essentially money you lend to governments or corporations, offering a fixed interest rate and repayment of the principal amount at maturity. Bonds are typically considered lower-risk than their stock counterparts.
Combining stocks and bonds in your portfolio can:
- Balance out stock market volatility
- Generate passive income through bond interest payments
- Help you achieve diversification and reduce risks
Related: Click here to read, “Employee Stock Ownership Plans: What Are They and How Do They Work?”
Finding the right mix of stocks and bonds depends on several factors, including your risk tolerance, investment timeline, and financial goals. For example, younger investors can typically tolerate a higher allocation towards stocks than investors that may be closer to retirement.
Diversification is a powerful tool for building a resilient and well-rounded investment portfolio. While it doesn’t eliminate all risk due to market fluctuations, it plays a vital role in managing risk and safeguarding your financial future. With the above steps in mind, you can feel confident that your portfolio is well-diversified and protected.
Protect Your Portfolio with Diversification
Wondering if your portfolio is taking on smart risks? Click here to get in touch with a member of our team and explore your financial planning options.
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