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Diversification
Diversifying
May Increase Your Chances Of Catching Results
Do
You Know What's Biting?
Fishing
is the art of convincing a fish that whatever is at the end of your line is
an edible
and tasty morsel. But different fish respond well to different types of
bait, so if
you want to be assured of success, you have to know exactly what’s biting
on any given
day — and what it wants to bite. Or, you could cover all bases, trying
flies for trout,
worms for walleye and crickets for bass. The more you diversify, the better your
chances of success. Similarly, as economic and market conditions have
changed, different
types of investments have thrived and faltered. Catching a winner isn’t
easy, but
“fishing” with three lines—a mix of equities, income investments, and
cash—may help
you achieve more consistent results.
Don’t
Let The Big One Get Away
Chances
are you’ve heard about the importance of diversification. Just as fishing
with three lines increases your chances of taking home a fresh catch,
holding more than one type of investment may increase your chances of making
a good return. When you have a mix of different types of investments —
when your portfolio is well-diversified — you can better weather the ups
and downs of the market. That’s because as the values of some types of
securities decline, the value of others may increase, creating a
“cushion” for your overall investment portfolio and providing you with a
return with which you are comfortable.
Testing
The Water
Let’s
look at three basic types of investments. Stocks, which are also called
equities, have the greatest potential for growth, but present the most risk.
Cash, which includes money market investments, presents the fewest
opportunities for growth, but is the least risky investment of the
three—although the slow growth rate of an all-cash portfolio poses risk to
your purchasing power over time. Bonds, which are called income investments,
have some potential for growth. They present more risk than cash but less
risk than stocks.
Trying
More Than One Pond
Generally,
a balanced portfolio will have a mix of all three investment types — but
diversification doesn’t end there. Just as there are many different
species within the classes “freshwater fish” and “saltwater fish,”
there are many investment categories within equity and income investments.
For example, equity investments are further divided into even narrower
investment types, or categories: growth-style and value-style investments.
Growth-style investments are stocks of companies that are expected to
experience rapid earnings growth resulting from strong sales, talented
management and dominant market positions. Value-style investments, which are
shares in companies that investors deem unattractive for some reason, tend
to be priced low relative to some measure of the companies’ worth. In
other words, value stocks are temporarily “on sale” — and value
investors are optimistic that they will become popular again and that their
prices will rise.
Equity investments are also divided by the market capitalization of a
company’s stock, which is the measure of the size of a publicly traded
company, as determined by multiplying the company’s share price by the
number of shares outstanding. This is why investments are referred to as
“large-cap” or “small-cap” investments.
The average investor can further diversify his or her equity investments by
spreading risk across different industries or geographical regions. Someone
who invests in one type of investment (such as stocks) and one investment
category (such as large-cap growth stocks) might spread risk by investing in
companies in a number of different industries or companies based in
different geographical regions, both domestically and internationally.
Similarly, bonds are categorized based on time-to-maturity and quality. An
investor who wishes to minimize exposure to risk may invest in a bond with a
relatively short maturity, such as a 3-month U.S. Treasury bill, instead of
a bond with a long maturity, such as a 30-year U.S. Treasury bond. Such an
investor would also want to consider bonds rated as “investment grade”
by Standard & Poor’s and Moody’s. For more information about risks
associated with bonds, please see When One Goes Up, The Other Goes Down:
Rising Interest Rates Could Mean Falling Bond Values.
Getting
More Bite For Your Bait
Investing
in mutual funds instead of individual stocks can ease the burden of
diversification, because the assets of each mutual fund are usually invested
in dozens of different companies — many more than most people could
probably afford to purchase on their own. But exactly how to diversify,
whether you invest in individual stocks and bonds or in mutual funds, can be
a challenge. How much to allocate among stocks, bonds and cash, as well as
how much to allocate among stock and bond categories, depends on your age,
your investment horizon, other demands on your dollars, your tolerance of
volatility and the size of your portfolio.
Diversification can also take effort. If you think your portfolio is
diversified and you can relax, you may want to reconsider. Suppose you have
an asset allocation of 55 percent stocks, 40 percent bonds and 5 percent
cash. Some part of your portfolio, such as stocks, may grow faster than
other parts, such as bonds. Eventually your portfolio will become
unbalanced. At the minimum you’ll want to be aware of this. In some cases,
you may want to reallocate assets in order to retain the appropriate
percentage of assets in each area, based on your investment needs.
Can
Your Portfolio “Tackle” The Market?
Creating
and maintaining a diversified portfolio can be a complicated process for the
non-professional investor. Your financial representative can help, both with
an initial asset allocation consultation and periodic portfolio checkups.
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