I hope everyone had a good Easter weekend. We certainly did. Our little Tyler had two Easter egg hunts that he thoroughly enjoyed. He’s a year old, so it was neat to watch him learn to look for and pick up the eggs. That aside, let’s talk about a nice topic for a Monday: Diversification.
When investing in stocks and bonds, one of the common terms you will hear is “diversification.” While this terminology is widely used, it is not always widely understood. I’ve had several people ask me questions about it. What does it mean to diversify? Why is it important to diversify? How do I know if my investments are diversified? Today’s post should help answer those questions.
The Idea Behind Diversification
We’ve all heard the phrase, “Don’t put all your eggs in one basket,” and we all understand why. If you have all your eggs in one basket and something happens to that basket, then you lose all of your eggs. If you instead split your eggs up into, say, four baskets and something happens to one basket, then you still have the eggs you put in the other three baskets.
The same general idea is true for investing. You should not put all your investment dollars into any one particular investment or even one particular type of investment. “Diversification” is just a fancy term for a simple idea: spread your investment money among different investments. This way if one investment or category of investments falls in value, your other investments will help insulate you. Now, even a well-diversified portfolio will not eliminate potential risk. There will be times (such as 2008 & 2009) when the stock market as a whole falls in value. But over time, a diversified portfolio of stocks and bonds is the best place for your retirement fund.
Let’s look at an example: John is 55 years old and has a 401k through his employer that he has been steadily contributing to for 20 years. Over those years, he has accumulated $300,000. In April, he receives his quarterly account statement, which shows the following investment holdings:
- Large-cap, Stock Index Fund: $150,000
- Large-cap, Technology Industry Stock Fund: $100,000
- US Government Bond Fund: $50,000
Is this a diversified retirement portfolio?
Red Flag #1
John has $250,000 (83%) of his money invested in stocks. A general rule of thumb is to subtract your age from 120, and the resulting number should be the percentage invested in stocks. For John, this would point to investing $195,000 (65%) in stocks. By actually investing 83%, he faces a larger risk of a stock market downturn that he wouldn’t have time to recover from by the time he wants to retire.
Red Flag #2
Of the $250,000 that John has invested in stocks, more than half of that is concentrated on stocks of companies in the technology industry. So, whatever happens to the technology industry will have a very large impact on John’s retirement account. This could be really good if technology stocks do well, but it could also be disastrous if technology stocks go down. A better suggestion for John would be to put his stock investments all in stock index funds. These funds have stocks in multiple industries and represent the overall stock market as a whole, rather than any one specific industry.
Red Flag #3
John has $50,000 invested in U.S. government bonds (Treasury bills, notes, and bonds) of various maturities. We already indicated above that using the general rule of thumb, he should have 35% ($105,000) invested in bonds. With the additional money to invest in bonds, one suggestion would be to spread that out into a couple different bond funds. It’s fine to have some money in U.S. government bonds, but you can also put some into corporate bonds and municipal (state & local government) bonds to spread things out.
Now, let’s see one option for John’s portfolio that is better diversified:
- Large-cap Stock Index Fund: $195,000
- U.S. Government Bond Fund: $50,000
- Corporate Bond Fund: $30,000
- Municipal Bond Fund: $25,000
This retirement portfolio has less exposure to stocks, which is appropriate for John’s age and proximity to retirement. It also reduces exposure to the technology industry and instead focuses on the overall stock market as a whole. This portfolio increases his investment in bonds, and spreads out his bond holdings among different categories rather than only holding U.S. government bonds.
Diversification is really a simple concept. Spread your investment dollars among different investments to help lower the risk of your entire portfolio going down. You’ll never be able to eliminate risk completely, but a well-diversified portfolio of stocks (of companies in various industries and sizes) and bonds (of various types) will help.