What Is A Diversified Portfolio
Diversifying your portfolio means spreading your money around into different types of investments. A diverse portfolio has investments in stocks, bonds, international securities, real estate, and cash. This does not mean you have to invest in every type security to have a diverse portfolio, but putting all your money into one investment is very risky. When diversifying your portfolio there are 3 main factors to consider:
• Age
• Risk tolerance
• Income
Diversifying Your Portfolio Based on Age
How old you are plays a significant role in how you should diversify your portfolio. Younger people can endure a higher risk in favor of greater returns, because they have time for their portfolio to recover if a worst case scenario happens. For older people, especially those nearing retirement, it’s important to minimize risk to avoid a catastrophe. A good rule of thumb is to take your age and subtract it from 100. The number you are left with is the percentage you should invest in stocks. For instance, if a 30 year old was interested in diversifying their portfolio he would invest 70% of his money into stocks.
Diversifying Your Portfolio Based on Risk Tolerance
Some people are risk takers and other are not. We all know that taking higher risk can lead to greater rewards, but it can also leave a portfolio in ruins. The first step to figuring how to invest your money is to figure out how much risk you want to take on. Sites like Etrade now have quizzes to help you determine your risk tolerance. Using this calculator you can quickly determine how to diversify your portfolio based on your risk tolerance. Etrade has several other tools available to help you properly plan a portfolio strategy.
Diversifying Your Portfolio Based on Income
Age and risk tolerance are the 2 biggest factors in determining how to diversify your portfolio. However, income can play a significant role for younger people. If you are earning significant income at a young age a riskier portfolio can help you reach retirement goals faster. Generally, as a young adult you want to take on higher risk in favor of higher reward potential. At 22, it’s a lot easier to start over then it is as a 60 year old. Putting your money in high reward investments gives you the opportunity to retire at a younger age.
Diversifying Your Portfolio
After you have considered your risk tolerance its time to make a plan to diversify your portfolio. This step is going to be different for everyone, based on their age, risk and income. No matter what you determine is right for you it’s important to consider putting money in several types of investments (even if you are a very big risk taker).
Stocks
Stocks are the most risky investment asset. They also offer the largest returns (over the long-run). In the short term stocks can be very risky. This is why its important to move away from stocks when nearing retirement to protect against the chance of a recession wiping out your savings.
When beginning your investment in stocks you should consider companies in several different industries. If you only purchase one stock or in one industry your portfolio will not be very diverse.
ETF’s
One way people can invest in multiple companies in the same industry is through an ETF (Exchange Traded Fund). ETF’s offer investors an investment in several companies, bonds, and other assets that represent the industry as a whole.
As an example Guggenheim Multi-Asset Income (CVY) has stocks and bonds in its holdings. ETF’s like CVY (ETF’s with multiple asset holdings) help investors diversify within particular industries. By holding multiple asset classes investors can diversify assets their portfolio with one investment. Now you don’t just want to go investing all your money in ETF’s, but they can help investors diversify their portfolio.
Bonds
Bonds offer steady and reliable income that you can reinvest or use to generate income. There are several types of bonds you can choose with varying levels of riskiness. These include
• Corporate Bonds
• Municipal Bonds
• U.S. Treasury Bonds
• CD’s/Commercial Paper
U.S. Treasury Bonds are considered to be a risk free investment. Municipal bonds are considered slightly more risky followed by corporate bonds. When choosing which bonds meet the needs of your portfolio its important to consider several factors. These include credit rating, interest rate, and principal. Municipal bonds can also be backed by taxation, but not always. It is important to learn all the information about a security before making an investment. Generally, Government bonds are safe and you do not have to measure risk (except for price risk). Corporate bonds and Municipal bonds do fail to make due on their promise to return principal from time to time so its important to analyze these securities more carefully.
CDs and commercial paper are considered money markets and not technically classified as a bond. They are short term borrowings (less than a year) where the issuer pays an agreed upon rate at the maturity of the note. These securities can be used to generate income with unused cash.
Other U.S. Treasury Securties
• Treasury Bills
• Treasury Note
• TIPS
Treasury bills are are bonds that mature in 1 year or less. They are sometimes called zero coupon bonds because they do not pay interest until maturity. Treasury notes mature between 2 and 10 years. They pay interest every six months and are sold in $1000 denominations. Tips are Treasury Inflation Protect Securities. When purchasing TIPS the coupon rate stays the same, but the principal is adjusted to the consumer price index (CPI). When the CPI rises the principal rises, and when the CPI falls the principal also falls. One bonus to investing in Government securities is you do not have to pay federal income tax on the interest you collect.
International Securities
International securities can be a great way to aggressively grow and diversify your portfolio. Investing in international stocks, currency, and bonds offers investors another way to mitigate risk. If investing in international securities you need to purchase stocks and bonds in that countries currency. You can also protect currency risk by hedging to further reduce risk. Using futures investors can safe guard their portfolio against the possibility of a foreign currency weakening against the U.S. dollar. This strategy helps investors buy into overseas businesses without taking on a currency risk as well as a securities risk.
Cash
You always want to have cash in your portfolio. Without having cash you will not be able to invest in new assets and seize opportunities as they may arise. A good rule of thumb is to maintain a 10%-15% cash balance.
Why Diversify Your Portfolio?
As the old saying goes “don’t put all your eggs in one basket.” The same rule applies to your portfolio. Sure, you can invest in one security and it can take off and make you rich. You can also hit the jackpot at the casino. The point of diversity is to protect yourself from huge price declines in a security. Companies can go bankrupt, new technologies can come out that completely change an industry, and industries become unprofitable over the coarse of many years (it would actually be an anomaly if you didn’t run into one of these problems with a security in your portfolio over the coarse of your lifetime). This is how diversity can help protect you from losing everything you worked so hard to get.
To make a well rounded diversified portfolio consider your risk tolerance, income, and age to determine what your investment needs are. Then begin planning what securities you are going to invest in. There are many tools to help you identify risk levels and they can even suggest types of securities will help fill those needs. Make sure to understand what your needs are before you begin investing so you have a goal to reach. This can help lead to retiring when you want and making sure you have enough money to last your entire retirement.
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