If you’ve ever listened to any financial planning ad (likely while watching CNBC), you’ve probably heard references to the ‘importance of a diversified portfolio.’
What the hell is Diversification?
I’m glad you asked… Diversification is, put simply, the concept of having a wide variety of assets in your portfolio. Yes, it’s exactly what you thought it was.
So, why the hype?
Diversification is an investing strategy that helps you reduce a serious amount of risk as it instructs you to not rely on one sole path and, instead, spread those hard-earned dollars across different opportunities.
Here’s some opportunities to consider:
- Stocks across multiple sectors and economies
- Real Estate
- Cash (or equivalents)
In the interest (see what I did there?) of getting technical, let’s touch on this beautifully uncomplicated, yet seemingly complicated, concept of multi-layer diversification.
When it comes to stocks, multi-layer diversification means: investing in multiple companies across the same sector. For example, you might want equal shares in Uber and Lyft because you use both equally and understand things like, well, the value of competition. You might bet on Serena more times than Venus, but you would never count Venus out now would you?
Great, Uber and Lyft it is. But say the tech sector isn’t exactly crushing it (see CNBC literally every day right now), you’d still be losing if you didn’t have investments in other, stronger sectors to make up this loss.
To broaden your opportunity and reduce your risk, you go to Investopedia and decide to buy Mosaic in the material sector as that area performed well in Q2. Boom, you’re on your way.
Oh….one more thing, all those companies are in the U.S. To really win the diversification game, you’ll need to pick up a few investments in international developed (like the EU) or emerging markets (like India or Brazil).
How much risk?
Your investment goals, like work, are all about deadlines. What type of goal and how long before you need to reach that goal will be everything to your multiple investment strategies.
For example, are you and your S.O. looking to buy that fab 2 bedroom, 2.5 baths in the next few years? You’ll likely need to access the investments you’ve made for that kind of expense. In comparison, your retirement ‘pot’ will be steady, patiently nesting beside you, growing in anticipation of your need for it much later on. That’s goal-based investing.
The further from your goal, the more calculated the risk you can feel comfortable taking.
10 Good + 10 Bad Doesn’t WorkDiversification can help you battle some pretty bad shit. You remember 2008-2009, right? Another solid strategy to leverage? Rebalancing.
Say you have 50 percent in stocks and 50 percent in bonds. If bonds are crushing it and stocks aren’t performing well, your allocation isn’t 50/50. To rebalance, you’ll have to sell the GOOD bonds and buy some not-so-great stock to get back to equilibrium.
This is what it means to BUY LOW. SELL HIGH.
Just like buying a house in a down-turn, you want to buy when the market is low to get the best price, in hopes that it will rebound (because…it always does) to then sell for a serious profit later. Oh, and remember to manage your goal-based asset allocation. Change your strategy based on your goals as your time frame speeds up (early retirement, alternative investment, etc.)
#Neverforget: Your gains & your losses should never determine your overall investment allocation.
Ok, so you want to dive in but you’re also a tad risk-averse. No worries, so am I. It’s what makes women betterinvestors once they take the leap. Hold onto it. Acknowledge its worth. And accept you’ll have to manage some risk to reap returns!
Here’s a few things to know that might help you accept the reality of risk:
All Weather There’s this portfolio called the All Weather Portfolio, which was created by Ray Dalio and introduced in Money Master the Game by Tony Robbin. It basically shows you how to create a completely diversified portfolio, designed to mitigate risk through varying economic strength. Here’s what that says:
- 40 percent Long-Term Bonds
- 30 percent Stocks
- 15 percent Intermediate-Term Bonds
- 7.5 percent Gold
- 7.5 percent Commodities
This breaks down the fact that stocks are three-times more volatile than bonds, making the amount of risk in a portfolio 3:1. FYI, there are a ton of different investment management firms that offer these All Weather portfolios.
Put simply, an efficient portfolio is an investment portfolio that offers the highest expected return for a given level of risk, or one with the lowest level of risk for a given expected return. This can be challenging if the percentage of return is low. You can work around this by introducing the concept of Margin.
Margin would allow you to take this portfolio which could yield 3 percent and leverage it twice to earn a 6-7 percent return. To double your return, you’ll need to borrow money from a brokerage firm at an interest rate of 1-2 percent.
Now you have doubled your buying power. If you buy things that increase in value, you’ve doubled your money and can easily pay back the brokerage loan. However, with life comes risk. If you lose money, you’ll still have to pay back the loan.
Futures contracts are another tool to use. A futures contract is a legal agreement to buy or sell a particular commodity or asset at a predetermined price at a specified time in the future. Futures contracts are standardized for quality and quantity to facilitate trading on a futures exchange.
Isn’t inflation a factor?
Yes. Let’s take a second to discuss this.
As a reminder, the value of our currency is determined by purchasing power, or the number of things/products/ services that money can buy. When inflation increases, the purchasing power of our dollar decreases.
The inflation rate in the U.S. is 3 percent YoY. Meaning, your $12 Kombucha will cost $12.03 next year. Thus, your $12 won’t cut the cost of the same item next year as your money depreciates over time. That’s why we don’t throw it all in a checking account (giving us 1 percent interest). Your money becomes less valuable over time.
Instead, we invest it to combat inflation. One is still less than three. Thus, your money is losing value in that checking account.
When the team of white dudes on CNBC talks about hedging, they’re referencing this same effect of inflation. What we call Treasury Inflation-Protected Securities can ‘hedge’ against pending inflation. They’re indexed against it and are a low-risk investment because they’re supported by our government.
The other, more volatile, investment category that can hedge against inflation? Commodities. They work as a hedge because, during periods of inflation, the price of commodities rises and so does your investment in them.
As we approach retirement age, we’re told to reduce our investment in stocks and increase bonds because we no longer have the time to watch the markets rise and fall. But, because of inflation and our growing life expectations, we can’t reduce the percentage too low.
We don’t know what that price tag for Kombucha will be in seven to 10 years. Instead, experts recommend keeping stock around 20 percent as another way to more safely protect, or hedge, against inflation.
If you skimmed over most of this article (which I get because it’s inexcusably long), just remember this:
- You want to invest your money across a variety of options, like stocks, bonds, real estate, and cash equivalents (like gold).
- Remember diversification is multi-layered. You want to spread the percentage that you do spend in one sector around to cover your bases (remember mix tech with materials, etc.).
- Understand how to invest based on goals. You should have some tucked patiently away for your golden years and some ready to do adulting right.
- Inflation is a real thing. Invest your money to make sure it grows over time.
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