Diversification is a general rule for successful investing. The common phrase “Don’t put all your eggs in one basket” describes diversification strategy. This strategy involves distributing your investment holdings among different asset classes in order to manage investment risk and reduce market value loss… in your portfolio.
Remember my Asset Allocation blog identifying three common asset categories; cash, equities and fixed income. Well, diversification goes beyond those categories. Equities for example can be broken down into its sub classes: large cap stocks, mid cap stocks, small cap stocks and international stocks. These asset classes help manage investment risk by allocating different percentages of your money to each class. >Risk is managed as certain classes offer different levels of return, meaning some investment classes will lose money, while other classes will grow.
Another level of diversification is sectors. Sectors are subsets of an industry, which describes the company’s business. Equities are grouped into ten sectors in the S&P 500 which are; Consumer Staples, Consumer Discretion, Energy, Financials, Healthcare, Industrials, Technology, Materials, Utilities and Telecommunications. Each sector performs differently based on the current market conditions. For example, if we are currently in a slow growth recovery market with a very low GDP expectation then consumers will most likely not be spending a lot of their money on unnecessary items which belong in the Consumer Discretion sector (Restaurants, Retail stores or Hotels). This sector of the market should have less exposure compared to say the Healthcare sector. A good way of investing in specific sectors is through Exchange Traded Funds (ETF’S). See my blog on ETF’s.
Now, most people think of diversification just for their equity allocation but you should also carry this over into the fixed income component of your asset allocation. Fixed Income (aka bonds) also has different classes: Treasury/Government bonds, corporate bonds, Preferred Stocks or Municipal bonds to mention a few. Similar to equities, bonds fluctuate in level of risk and return. A portfolio should hold the appropriate bond percentages based on current market conditions and your risk tolerance. Bonds have credit ratings that make them either a safe investment or higher risk investment known as junk bonds.
Diversification is important and will allow your investments to grow as your money is spread out globally and not invested in just one part of the market.
Rebalancing is bringing your portfolio back to the original asset allocation weightings you selected for your investment goal. You may need to rebalance because an asset category has increased too much due to high returns, therefore you would trim the winners and reallocate the proceeds to asset categories that have underperformed.
Another way to rebalance your portfolio is if you make contributions. The new contributions will need to be invested based on your asset allocation and more of the contributions may go towards the underweighted categories to bring your portfolio back into balance.
It is important to remain disciplined and take action on rebalancing. You should consider doing this once a year and you will pick up additional return in your portfolio over time.
Good luck and know what you are invested in.