Sometimes it’s helpful to think of investing like football. You need an offense, a defense, and special teams. When the stock market is increasing, you want your offense playing. When the market is down, you need to put the defense in. And in weird scenarios, like when there’s an unexpected global pandemic, you want to have special teams.
So how does this analogy translate into investing? There are different types of investments, and they all perform differently in different situations. You want to make sure you have investments that can play offense, defense, or special teams depending on the situation.
In other words, you want a diverse array of investments. Or, in industry-speak, you want to diversify your assets. Let’s talk about diversification.
Understanding asset classes
Groupings of investments — stocks, bonds, real estate, commodities —are known as asset classes.
There are groupings within an asset class, as well. With stocks you have categories of stocks, like growth or dividend. You can also group stocks according to their industry: tech stocks, financials, industrial stocks and so on.
For bonds, you can categorize them by issuer, such as bonds from the U.S. treasury or corporate debt issued by companies. You could also categorize bonds by risk-level: investment grade or high-risk.
A truly diverse portfolio is invested in different asset classes and also holds diverse investments within those asset classes. Let’s take a closer look.
How diversification works
At the highest level, you want to invest in a wide variety of asset classes. That means it’s better to invest in both stocks and bonds than to invest in stocks alone.
Stocks and bonds perform differently and react to different things. Their performance isn’t correlated, so to speak. That means if there’s a big dip in the stock market, having part of your portfolio in bonds can help protect you from that dip. So even young investors with aggressive portfolios might want to keep a small allocation of bonds to play defense.
On the other hand, if you’re largely invested in bonds and interest rates are low, having part of your portfolio in stocks serves as your offense. It can help prevent your portfolio from stagnating.
Next, we go down a layer and think about how to diversify within an asset class.
Take stocks as an example. If someone in the 90’s was invested primarily in tech stocks, they would have been hit hard when the dot-com bubble burst in 2000. If that same person had also invested in banks, retailers, pharmaceutical companies and energy stocks in addition to tech stocks, they may not have been affected as significantly.
The same applies to bonds. With interest rates near record lows, a portfolio made up entirely of 10-year U.S. treasury notes isn’t going to return much interest. However, if you also own corporate bonds, municipal (muni) bonds, or bonds from other countries, you might see a bit more income from that portfolio.
Building a diversified portfolio
The good thing about diversification is that a little bit goes a long way. In fact, research shows that after a certain point, the benefit of adding new types of investments starts to diminish.
The best way to diversify is to find assets that are not correlated. To see how this plays out in real life, consider the chart below.
If you were invested in only U.S. stocks from 1998 to 2018, your money would have returned just under 7 percent on average. There’s also a one-year period where the portfolio fell 37 percent.
Now consider a diversified portfolio over that same period: 20 percent in U.S. bonds, and 16 percent in international stocks. The rest (64 percent) is in U.S. stocks. By adding this diversification, your worst year is now a loss of 30 percent — still significant but less jarring than 37 percent. Meanwhile, you haven’t compromised too much on returns.
(Source for charts: MorningStar)
When determining how to diversify assets, I build a personalized portfolio based on your goals, risk tolerance, needs and more. We combine different assets and asset classes designed to help you reach your goals, while minimizing turbulence along the way.
If you want to talk about diversification in your portfolio, let’s find a time to discuss.