The Needle or the Haystack – How Important is Diversification?
As the uncertainties of the COVID-19 pandemic continue, more individuals are looking into preserving, and hopefully, increasing their net worth. Among the many investment best practices, portfolio diversification has become one of the core strategies for those looking to build a healthy, resilient portfolio.
So, how could portfolio diversification impact your net worth, and what are the best ways to diversify?
What is Portfolio Diversification?
As always, let’s begin with the basics. What exactly is portfolio diversification? Put simply, it is “the practice of spreading your investments around (Fidelity.com).” Therefore, in a diversified portfolio, you would see a wide variety of investment items. It might even be a mixture of short-term and long-term investments. Most important is that diversification include multiple investments that do not tend to move in sync with one another based on economic and market developments.
With our firm headquarters office located in the world’s energy capital, we often start conversations with corporate executives who believe they have diversified investment portfolios because they own a list of various energy stocks that have different management teams and operate in different parts of the energy markets. That may “feel” diversified, but it fails to account for the fact that overall demand for all energy products can be impacted by a slowing in economic activity, with pricing and profits adversely impacted. Diversification is more than the number of items listed on your brokerage statement.
As a result, creating portfolio diversification is considered intimidating by some as one of the more complicated investment principles. Thus, it is often delegated to well-trained financial advisors specializing in professional portfolio management.
Biggest Benefit of Portfolio Diversification
When thinking about investing, our natural human inclination is to seek to put our money in the very best investment opportunity we can find through research. That is looking for the “needle.” If you pick correctly, of course, the results are outstanding. But obviously, if your one needle from the haystack goes up in smoke or blows away, your loss is total. So, what is the biggest benefit of portfolio diversification? Of course, it is resilience. Because you won’t be putting all your eggs in one basket, you become much more adaptable against market volatility.
Portfolio diversification makes it very unlikely that a change in one single investment or one specific category of investment would completely sabotage your portfolio. For example, even if the stock market takes a plunge, you may have enough of other non-market investments to fund needs while you sit out the fluctuation or even mitigate or absorb the negative impact the market brought.
Minimizing Overall Risk
In other words, the biggest benefit of portfolio diversification is the confidence you gain in being able to minimize your overall risk. This doesn’t mean the risks are taken away. Instead, it simply means that, overall, you’re at a lower risk of suffering severe loss.
Increasing Investment Efficiency
Having a diversified portfolio saves you time to monitor and manage your assets. That’s because not all assets perform similarly, and everything rarely suffers a significant impact simultaneously.
Therefore, you don’t need to fixate on one market, nor will you feel the pressure of having your return completely tied to a single form of investment. Instead, you can let everything naturally develop and only monitor the overall performance.
Helping to Achieve Long-Term Goals
Because of the investment stability of building a diversified portfolio, many people find that their long-term goals are more defined and potentially achievable. The reasons are simple. Long-term investment goals involve better planning, which allows you to build a good mixture of investment products. The broader and more properly diversified that mix, the more probable it becomes to accurately forecast the possible outcomes for your portfolio – the good, the bad, and all in between.
Since you look at a longer timeline, you won’t feel the pressure of maximizing return within a short timeframe, often in exchange for taking on higher risks.
Diversifying Beyond Just Stocks
The most popular item to add to your investment portfolio is domestic stocks, and many misunderstand the idea of diversification. Investing in various stocks doesn’t necessarily mean a diversified portfolio, as the stock market as a whole can be by nature highly volatile.
Therefore, it’s important to highlight a few other options beyond just stocks the next time you decide to diversify your portfolio.
Bonds provide regular interest payments. Therefore, they’re often considered safer, more predictable, investments and more suitable for those with a lower risk tolerance. Bonds are also great to have if you have a larger amount invested in more volatile investments, such as stocks. However, bonds typically have a lower total return potential compared to other options. This differential in return potential is magnified in the current low-interest-rate environment.
If you feel comfortable holding a certain amount for a fixed timeframe, a short-term Certification of Deposit (CD) or other similar bank instruments might be the right option for you.
Short-term CDs typically are guaranteed by FDIC, offering plenty of safety compared to conservative short-term options such as a money market fund. However, investing in CDs means you’re giving up some liquidity by locking your funds in. And like bonds, interest rates offered are low in the current environment.
Therefore, it’s best to speak to a financial advisor or a banker to see if a short-term CD is your best option.
Real estate is a popular form of investment right now and there certainly are sound reasons to consider it. You can either invest in physical real estate or choose a real estate fund with liquidity, such as Real Estate Investment Trusts (REITs).
Investing in physical real estate may generate a passive, secondary income flow for you (rental properties). However, physical real estate investments can be expensive and often require considerable capital to begin with. On the other hand, REITs have a much lower capital requirement to invest, allow you to receive stable dividend payments (hopefully growing over time), and it’s also easier to sell REITs. Unlike owning physical real estate, REITs don’t come with any tax breaks that might help you offset other taxable income.
Preserving Your Net Worth
In conclusion, the biggest benefit of proper portfolio diversification is to minimize and properly mitigate risk, providing you more confidence in your long-term investment outcome. It helps you preserve your net worth, but also allows you to grow your overall asset to reach your long-term investment goals.
Remember, diversification is more comprehensive than just increasing the length of your “list” of investments owned. You need to mix together investments that have characteristics that complement one another for more predictable, diversified, long-term returns. Your final decision will be based on your risk tolerance, your financial situation, your future anticipated needs, and your investment timeframe. At the extreme, you can follow the advice of Vanguard founder, Jack Bogle, who said, “Don’t look for the needle in the haystack. Just buy the haystack!”. That statement represents the opposite extreme from the single needle approach. Diversification starts somewhere in between the needle and the full haystack.
If you are unsure about doing it on your own, it is best to speak to a comprehensive financial advisor to determine the best way to diversify your portfolio and allocate your assets.