A Look at Diversification
Ancient Chinese merchants were said to have developed a unique way to manage their risk. They would divide their shipments among several different vessels. That way, if one ship were to sink or be attacked by pirates, the rest stood a good chance of getting through. Thus, the majority of the shipment could be saved.
Your investment portfolio can benefit from that same logic.
Diversification is an investment principle designed to manage risk. However, diversification does not guarantee against a loss. Let me repeat, diversification does not guarantee against a loss. The key to diversification is to identify investments that may perform differently under various market conditions.
On one level, a diversified portfolio should be diversified between asset classes, such as stocks, bonds, and cash. On another level, a diversified portfolio also should be diversified within asset classes, such as a diverse basket of stocks.
A Diversified Approach
For example, let’s say a stock portfolio included a computer company, a software developer, and an internet service provider. Although the portfolio has spread its risk among three companies, it may not be considered well diversified, as all the firms are connected to the technology industry. A portfolio that includes a computer company, a drug manufacturer, and an oil service firm, however, may be considered more diversified.
Similarly, a bond portfolio that invests exclusively in long-term U.S. Treasuries may have limited diversification. A bond fund that invests in short-term and long-term U.S. Treasuries, plus a variety of corporate bonds, may offer more diversification and may actually enhance returns as well.
Mutual Funds and ETFs
The concept of diversification is one reason why mutual funds and Exchange Traded Funds (ETFs) are so popular among investors. Mutual funds accumulate a pool of money that is invested to pursue the stated investment objectives of the specific mutual fund. The fund may have a narrow objective, such as the auto sector, or it may have a broader objective, such as large-cap stocks. ETFs also can have a narrow or broader investment objective. Keep in mind, though, the narrower an investment objective, the more limited the diversification. Furthermore, a narrow investment objective may result in more volatility and additional risks associated with a particular industry or sector.
The concept of diversification is critical to understand when you are designing and evaluating a portfolio. If you want more information on diversification or have questions about how your money is invested, please call us to review your situation.
If you are curious as to the differences between Mutual Funds and ETF’s, stay tuned for our next blog post.