Reading the business section of any newspaper or website can be intimidating, and not just because of the dizzying array of statistics, charts and tables. Financial news has a way of frightening some readers when there is actually little cause for alarm. That’s because with the right investment strategy, the risk of being adversely impacted by any one gloomy headline might be reduced. The cornerstone of this type of financial planning is a diverse allocation of investments.
Why diversity is key
The common saying, “Don’t put all your eggs in one basket” is just as relevant in the world of finance as it is in daily life. For example, it’s rarely a good idea for someone to quit their job only to pin all their hopes on landing a dream position at a big-name firm. While the reward may be high, the risks make it inadvisable. A more reasonable plan might be to apply for a number of other positions as well as the dream job. This can reduce the risk of failure while increasing the chance of success at finding a job.
This is a simplified example of how diversity reduces the chance of loss in an investment strategy. As the U.S. Securities and Exchange Commission explained, an investment portfolio that includes several different kinds of assets has a better chance of weathering market fluctuations than one focused on a single asset. Every investment involves some level of risk, but a diverse mix of investments can spread this out.
A broad mixture of asset classes makes for a diverse investment portfolio. But that doesn’t mean blindly choosing any fund that strikes your fancy is a clever way to approach an investment strategy. Instead, investors need to understand the difference between two basic types of assets, and then balance these out accordingly.
Balancing asset classes
Investment assets can be broadly categorized in two ways: stocks and bonds.
- Stocks are also known as equity instruments, as the Federal Reserve Bank of San Francisco explained. Stocks are probably more familiar to the novice investor, since they can involve purchasing partial ownership in one specific company. The nature of the stock market allows for the possibility of producing returns in a relatively short amount of time. But with high reward comes high risk – those returns could disappear almost as quickly as they came.
- Bonds are also called debt instruments. When investors purchase a bond, they are buying a promise to be repaid with interest in a specific time frame. Some bonds can take years to “mature,” or reach the point that all of this initial investment has been paid. This makes bonds generally less risky than stocks, with the caveat that they tend to return less as well.
Achieving a diverse portfolio requires a good mix of stocks and bonds, but it doesn’t always mean an even split between the two. As the SEC’s Investor.gov page explained, it can be advantageous to hold more stocks than bonds, or vice-versa, depending on your age. Since returns from equity assets can fluctuate, many younger investors are advised to prioritize stocks over bonds. Once they start nearing retirement age, however, it’s usually a good idea to begin re-balancing the portfolio to favor less risky bonds.
This is only one piece of the diversification puzzle. By working with a trusted financial advisor, investors can not only gain a deeper knowledge of the finer points of finance, but also feel comfortable that all the details are in order. Your eggs should be in multiple baskets, but everyone could use a little help understanding how to manage them.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Diversification does not assure a profit nor does it protect against loss of principal.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.