You hear it all the time from investment professionals and nonprofessionals alike: Investors need to diversify. But what does that really mean? For some people trying to do the right thing, their method of diversification can actually be a series of bad decisions. It is time to examine what diversification means, why should you do it, and how can you do it the right way for you.
Let's start with a diversification explanation. Simply put, it is a way to get the most out of your investments while reducing your overall risk. With diversification, you are assuming that as one area of the market goes down, another will most likely go up. By dividing your investments into different areas, you are looking to bear the fruit of whatever is in favor at that time and minimize your losses in what has gone out of favor. The market can be extremely fickle, and what was producing results one year may not produce similar results the next. You'll want a variety of investments to try to capitalize on the movement of the markets from one day to the next.
Once you understand the concept of diversification it shouldn't be too hard to achieve, right? You're right, as long as you do a little bit of research. Diversification can come in many shapes and sizes. For instance, you can diversify between stocks and bonds, international and domestic, large and small companies, stable and emerging markets, long and short bonds, and so on.
Even though there could be endless permeations to diversification, don't get discouraged. Figuring things out can be very simple. You'll want to make sure to avoid some of the more basic traps some investors fall into when they get started.
A common mistake investors make with diversification is placing equal amounts of their account balance into every fund. While the intent is in the right place, the strategy is a bit flawed. Diversification takes more decision-making based on your investment preferences, your investment goals and how much time you have to reach those goals.
A very basic rule of thumb for diversification is to take 120 and subtract your age. The remainder is the percentage you should invest in stocks, everything else in bonds. But this is too basic for most people. A truly diversified portfolio should incorporate a variety of asset classes and should be based on your own situation. Use an online asset allocation modeling calculator to give you a sense of what a diversified account would look like based on your goals.
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Another misstep investors take with diversification is not rebalancing on a regular basis. As one area of your account, stocks, for example, continues to grow, it can become disproportionate to your original diversification request. If you don't rebalance, or move the account to meet your original diversification boundaries, then you could be taking on more risk than you intended. The easiest thing to do to avoid this error in investing is to take advantage of rebalancing features offered through some investment platforms, or schedule rebalancing two to four times per year on your calendar and stick to it.
With a properly diversified account, you will be able to take advantage of different areas of the market while lowering your overall risk of investing. There is no guarantee with investing that you can prevent a loss, but a diversified outlook can reduce the effect of negative performance in one particular area. The key is to find balance between your tolerance for risk and your desire for return.
Scott Holsopple is the president and CEO of Smart401k, offering easy-to-use, cost effective 401(k) advice and solutions for the every-day investor. His advice has been featured on various news outlets including FOX Business, USA Today and The Wall Street Journal. Keep tabs on Scott on Twitter and Facebook.
The information set forth in this article should not be construed as individual investment advice. Actual portfolio allocation determinations should take into account a variety of personal factors, including your own risk tolerance and other individual circumstances.