Most investment professionals agree that diversification is the most important component of reaching long-range financial goals while minimizing risk.
Craig Cecilio, the founder of DiversyFund, knows that true diversification requires diversifying not just within an asset class but to diversify among other asset classes like real estate. A combination of asset classes outside of stock and bonds can reduce your portfolio’s sensitivity to market swings.
There is one primary reason to have a diversified portfolio: diversification minimizes risk and mitigates the economic downturns that occur within specific sectors. For example, the economic downturn of 1999 began in the high-tech industry. Holdings that were overweight in high-tech stocks and Internet startup companies took a beating, often to the point of plummeting from 100 to zero overnight.
For every Google or eBay success, there were hundreds of utter failures. The sock puppet from Pets.com came out in better circumstances than those who invested in that company. Similarly, portfolios that were heavily invested in bank stocks saw tremendous losses in 2008, including dividend cuts by many of the major megabanks that had a long and strong history of dividend increases. In 2016, energy companies suddenly found themselves with too much product and too few buyers. The drop in the price of a barrel of oil from $120 at its peak to $22 resulted in a similar decrease in the value of oil company stock prices. Royal Dutch Shell shares, for example, were selling for $80 each in 2012 and are now selling at the bargain price of $53. Investors who spent their dollars chasing returns before the bubbles in each of these sectors took the most significant losses after those bubbles burst.
Investors who buy individual stocks can diversify their holdings quite easily. They can research different companies that represent the best overall long-term performance in their industry, see if the stock meets the portfolio goals of growth, income, or a combination of both, and make purchases accordingly.
Investors who utilize mutual funds will have to dig deeper in terms of obtaining the information on the sectors and specific companies’ stocks each fund holds. Mutual funds already offer the investor a market-basket mix of stock and bonds. Many mutual funds invest in the same basket items depending on the fund objective, so duplicating efforts creates redundancy as well as increasing risk. For instance, both Vanguard and Fidelity offer funds focused on aggressive growth. A close look at each shows that both own Apple stock as a core holding and both are heavily invested in information technology stocks. To own both offers no real diversification, as the funds tend to duplicate one another. A better mix would be to purchase funds having different objectives, such as owning one that invests solely in large, mature companies (large caps) and another that owns strictly smaller companies that are poised to grow. Add in a third fund that offers price stability, such as one offering corporate or municipal bonds, and the element of risk due to market fluctuations or economic cycles is further mitigated.
For the investor who is just starting a portfolio, the simplest method of ensuring portfolio diversification is to purchase shares in an index fund. The stock holdings in these funds replicate the stocks used to produce the Dow Jones or S&P 500 average. The holdings cover consumer staples, energy, banking, retail, manufacturing, and insurance. Owning an index fund means that the investor owns the market. A good index fund should mirror the Dow Jones Industrial Average or the S&P 500 Average almost to the decimal point. Index funds aren’t sophisticated or sexy, but they are a good place to start.
Investors should also consider adding alternative investments like commodities (like gold), hedge funds, collectibles, and real estate to the portfolio. The 1% have been building wealth with real estate for centuries. One way to diversify in real estate is through a real estate investment trust (REIT). REITs allow investors to diversify their portfolio without the difficulties of directly acquiring property. REITs invest large amounts of money into residential multifamily homes, commercial buildings, healthcare facilities, and large-scale industrial buildings as well.
The individual who wants to build wealth over time should be more concerned with managing risk than with chasing returns. Diversification over sectors and asset classes provide more stability to a portfolio without severely limiting returns.
About: DiversyFund was founded to help everyday investors build wealth like the 1%. The company opens up real estate investing to the average person by breaking down traditional barriers to entry such as high minimum investments and unnecessary broker fees. Through their online platform, they are helping investors diversify their asset portfolio beyond stocks and bonds.