Time to for another financial tip Friday. For this weeks edition I want to talk about diversification. Diversification is key when putting together any kind of investment/retirement portfolio.
What Does Diversification Mean?
Simply put diversification means don’t put all of your eggs in one basket. In other words, you shouldn’t have all of your investments in mutual funds that invest in stocks or in bond, but a mixture of both. I also consider my house to be part of my portfolio. I don’t look at my house as an investment, but it certainly is an asset. I know that if I needed too I could tap the equity of my house (although there isn’t much) for some money if I needed something. I don’t plan on tapping that equity, but I still think of it as part of my investing portfolio. Generally, houses go up in value, albeit it at a much slower rate. Typically, housing prices rise about 3-4% a year. Yes, you can have boom towns, but those eventually go bust. I prefer the slow and steady for housing gains and don’t count on constant double-digit returns. A mentality like that got a lot of people in trouble during the 2000s when people used their houses like ATM machines. They just thought housing prices would go up forever and we know how that turned out.
So when it comes to diversification I think a mixture of stocks, bonds, real estate is certainly part of how you should approach investing. I stay away from precious metals like gold because they are TERRIBLE investments.
What Kind of Diversification Mixture Should We Have?
For most people that is the key question in their investing lives. When it comes to diversification, although my house is part of my asset classes, I really focus on diversifying my investment portfolio (e..g stocks and bonds). I don’t buy real estate because I don’t know how to invest well and as Mrs. ROB says you can’t fix anything (which is pretty much true….she is the handy one in our household). So I stick with investments.
So there are two things I like to think about with diversification. First, what should be the mixture of stocks and bonds in your portfolio. The larger percentage of stock mutual funds (funds that only invest in stocks) as a portion of your overall portfolio the riskier it is. For example, if you have 90% stocks and 10% bonds then that is riskier than someone who has 60% stocks and 40% bonds. However, the more aggressive you are the more apt your to better your return. Only you can tell determine what your risk tolerance is.
For full disclosure my current portfolio is about 95% stocks and 5% bonds. However, I don’t have a problem with investments going up and down. In this latest downturn I lost about 10% of my holdings (since that time it is off only by about 4%). I actually tried to up my investments more because I have confidence that the market will go up.
This type of diversification is really based upon your age. The older you get investment advisers recommend less in stocks and more in bonds to provide a little more stability in your investments and if the market goes down it won’t go down as much. I personally love balanced funds as a way to get this diversification and plan on investing more in the future.
A second type of diversification is depending on your stock/bond split, whatever makes you comfortable, how do you determine what KINDS of stock funds to invest in. This is where it can get tricky. Unless you know the differences between large-cap, small-cap, international, mid-cap, etc it can be confusing (I hope to write a post someday explaining the differences). That is why Index funds have the most money in them. In fact, you can buy different types of index funds where you are basically buying the entire market. For example, the Vanguard Total Stock Market Index Fund (VGTSX), in essence, buys most of the stock market. That is why it is called the Total Stock Market Index Fund. Fidelity and Schwab have similar products that do the same thing. The advantage of these funds is that they have low fees and you receive instant diversification.
You can also buy different types of index funds. In my personal portfolio I have total stock market index fund, a mid-cap index fund, international, small-cap, and large cap. In other words, I invest across all different fields of stock investments. This provides me the diversification I need in my own portfolio.
You might ask if I advocate an index fund then why aren’t all my investments index funds? That is a good question and the reason for that is because it isn’t offered to me in my primary retirement account. I have index funds, but I don’t have a good one where I can buy the entire market. So I have to cobble together funds across different asset classes (and that is all small-cap, mid-cap, and large-cap funds are they are different asset classes. Small companies, mid-size, and large (e.g. Apple) to create my own diversification. Also I don’t mind a little more risk and a couple of the funds I invest in are a little riskier than the normal index fund.
An Investment Portfolio For You
If your head is spinning with all of this information I don’t blame you. I am no expert but I think I can talk about investments pretty well and I am constantly learning things. For most Americans they don’t want to take the time to learn. So how can you get diversification, invest in mutual funds, and still create a lasting portfolio.
There are a number of ways, but there are many people who simply recommend you put your money into basically three funds: A total stock market index fund, an international index fund, and a bond index fund. It is called the three fund portfolio. It is pretty simple to create and maintain. The two things you have to ask yourself is: 1) can you get access to these kind of index funds in your own investments; 2) what percentages do you put into each?
If I were doing this type of portfolio (and I plan on doing it when I retire) I would have, because of my age) 65% in the Total Stock Market Portfolio, 25% in International and 10% in Bonds. However, I don’t mind being aggressive.
You need to do your OWN research. Don’t just take my word for it. Always, always, always try to learn about this stuff yourself. It is too important of a subject not to learn about. And it doesn’t take a lot of time. You can go to sites like Investopedia or other sites to help you out.
But diversification is key to lowering your risk in investing. The old adage of not putting all of your eggs in one basket is true. Don’t invest in just one thing. Diversify. Have different types of stocks and bonds or even real estate. You can have your own mixture, depending on your own knowledge, but diversify, diversify, diversify.