How Diversifying your Portfolio Can Mitigate Risk
Risk is an inherent part of investing. After all, no one can control the losses or gains of a particular asset, sector, or the market as a whole. But you can take steps to manage your risk by diversifying your portfolio. Here’s a look at what diversification is, why it matters, and how to do it.
What is diversification?
Diversification is a technique that reduces risk and volatility in your investment portfolio. The idea is to invest across various asset classes, industries, and categories in an effort to reduce losses if a particular investment does poorly.
Imagine you held just a single stock. If that stock price plunges, so does the value of your entire portfolio. However, if you held 100 different stocks, when one stock’s value decreases, other stocks in the portfolio may hold their value or even increase in value, mitigating the loss. Holding several different asset classes, such as stocks, bonds, and real estate, further distributes your risk.
Diversifying across asset classes
Different types of assets come with varying levels of risk. For example, stocks have high growth potential and are relatively volatile, while bonds tend to offer less growth but are generally less risky.
Additionally, different asset classes may not respond to market conditions in the same way. In other words, they may not be correlated. For instance, an event that sends stocks plunging may have little effect on the bond market and vice versa.
You can also strengthen your approach by diversifying within asset classes. You may want to buy stock in companies across sectors, such as technology, industrials, or consumer staples. You may also consider buying companies of different sizes and across geographies. For example, large-cap companies may offer more stable returns than their small-cap counterparts, but small-cap stocks may offer more growth potential. Additionally, when domestic stocks are doing poorly, foreign stocks may be doing better.
When diversifying within bonds, consider that high-yield bonds don’t correlate perfectly with investment-grade bonds. You might also want to consider buying across different regions as well.
The role of mutual funds, exchange-traded funds, and index funds
Mutual funds, exchange-traded funds (ETFs), and index funds are other options, especially if the thought of selecting a diverse mix of investments yourself sounds intimidating. Mutual funds allow you to pool your money with other investors in a collective fund that is invested in a pre-selected mix of assets. These can include stocks, bonds, commodities, and other securities. Most mutual funds hold more than 100 securities, giving them a level of diversification that would be difficult to achieve for most individual investors.
Index funds and ETFs are similar to mutual funds in that they hold a diverse basket of investments; however, they are managed differently. Mutual funds are typically managed by a professional portfolio manager who actively selects securities to invest in with the goal of beating the market. This type of active management can make funds more expensive to hold. ETFs and index funds, on the other hand, are usually passively managed and designed to track the performance of a specific index, such as the S&P 500. They may provide a cheaper alternative to actively managed funds.
Diversification does not eliminate risks or prevent investment losses entirely, but it does offer some protection against potential downturns by ensuring your portfolio includes investments that continue to grow while others may be declining. The further your portfolio sinks during a downturn, the longer it takes to recover, and diversification helps ensure you won’t have as far to climb when markets begin to rise again.
Sources:
https://www.sec.gov/reportspubs/investor-publications/investorpubsinwsmfhtm.html
This information was developed by the Oechsli Institute, an independent third party. The opinions of the Oechsli Institute are independent from and not necessarily those of RJFS or Raymond James. This information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. Investments mentioned may not be suitable for all investors. Past performance may not be indicative of future results Investing involves risk and you may incur a profit or loss regardless of strategy selected, including diversification and asset allocation. Every investor's situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investors should consider the investment objectives, risks, charges and expenses of an investment company carefully before investing. The prospectus contains this and other information and should be read carefully before investing. The prospectus is available from your investment professional. The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns.
