One of the long-held tenets in investing is diversification. It is commonly explained by the oft-quoted phrase, “Don’t put all your eggs in one basket.” Diversifying your investments is especially important when you are investing for retirement. So what exactly is diversification?
Diversification refers to a technique of managing risk by putting together different investments in a portfolio. The reason why you need to put your investments in many different asset classes such as stocks, bonds, cash savings and real estate and spread your investments in each class further is because on the average, a well-diversified portfolio poses lesser risk and higher returns than one that is concentrated only on a single asset class or industry. Diversification works because when certain investments are having a bad run, their negative performance will be offset by those that are performing very well.
In order to reduce risk, studies have shown that a portfolio that is well-diversified is comprised of at least 25 stocks. However, investors who don’t have that much cash will find it difficult to invest in 25 different stocks with the amount they have. Thus, mutual funds have become the investment vehicle of choice for small time investors. Because mutual funds pool together the monies from all their investors, they are able to provide individual investors with a well-diversified portfolio even if they don’t have a huge amount to invest.
What would happen if you don’t diversify your nest egg? You’re basically putting your portfolio at a very huge risk. Yes, you’d end up with substantial gains if your investment is doing well. However, if the market slides and your investment strategy is hinged only on stocks, you would suffer great loss. Diversification helps ensure that your portfolio is not exposed to this amount of risk.
The importance of diversifying your portfolio cannot be underestimated. The next question now is: How do you do it? These are the steps you need to take:
1. Make mutual funds part of your investment portfolio.
Mutual funds and exchange traded funds or ETFs allow you to diversify your nest egg for a smaller amount. However, it’s important that you don’t just invest in a single fund. While you may have many different companies in your nest egg if you invest in US stock funds, your portfolio is still not well-diversified since it’s only limited to stocks found in the US.
To diversify, you can invest in many different kinds of mutual funds. Aside from US stock funds, you can also include bond funds and international stock funds. The good thing with investing in global funds is that they usually move in the opposite direction as US funds, giving your nest egg a degree of protection from downturns in the US economy.
In the long run, stock funds provide higher returns. However, they are also much more volatile and are prone to price fluctuations. Bond funds, meanwhile, are more predictable but don’t give as high returns. It’s important to have these two kinds of funds in your nest egg because they move in opposite directions. When stocks fall, bonds usually go up and vice-versa.
2. Be prudent when choosing individual stocks.
As a beginner investor, you should not harbor any notions that you can beat the market—even if you have done and have time to do (even more) research. Even the most experienced stock market professional cannot even do so. Thus, it is extremely important that you exercise prudence when investing in individual stocks. Make sure that you do due diligence on the companies you want to buy the stocks from. Once you are sure that you want to keep the stocks, a “buy-and hold” strategy is best as frequent trading is going to diminish your returns. It’s also important to limit your individual stock picks to only a small portion of your nest egg.
3. Review your stock and bond allocation regularly to see if it is still in consonance with your personal financial goals.
Once you have formed your investment portfolio, you can’t just let it rest. You’ll need to do a regular review of your portfolio, at least once a year. It’s important that you look at your allocation regularly so that you will see if you need to make any adjustments. For example, when you are still younger, you can afford to own more stocks because of the high returns you are likely to earn from them. Even if there will be years when the market will perform poorly, you’ll still have time to recoup your losses.
As you draw nearer to retirement, however, you might need to lessen your allocation of volatile stocks and put more in bonds which are safer and provide a more predictable source of income. With this strategy, you are assured that even if your stocks tank, your bonds will still be a source of earnings.
The neophyte investor is bound to make a lot of investing mistakes. While some of these may not cost you much, you are far better off if you steer clear of them. Let’s look at some of these missteps so that you can avoid them and maximize the returns of your investment:
Not diversifying your portfolio
Since we have discussed diversification extensively above, let’s tackle the lack of diversification first. The unpredictability of the stock market makes diversifying your portfolio necessary. When you invest across different asset classes and in various industries, your nest egg is better able to withstand the fluctuations of the market. Aside from mitigating risk, your portfolio is in a more likely position to reap more earnings over the long-term.
Not understanding the reason why you are investing
Before you can begin to invest, you need to have a clear understanding of why you are investing in the first place. Many neophyte investors just put their money in stocks, bonds or mutual funds without really knowing why they are doing so. If this describes you, craft your investment goals before you continue to move forward. Without your goals, you’ll never know if you have already succeeded in your investments or not.
Not following a regular investment strategy
If you want your investments to grow, you need to make regular investments. Doing so will enable you to make compounding work for you. Whether you pledge to invest a $100 or more each month, what’s important is that you are consistent.
One particular “investment strategy” that you should avoid is following “hot tips” from friends or coworkers about a particularly promising stock. You might have heard of an unknown company whose stock is set to soar or a large company whose stock was severely undervalued but is now bent on making a comeback.
These tips largely encourage those who hear them to invest in the stock. Unfortunately, these tips are rarely true. It’s best to check out the background of the company and if what you hear doesn’t jibe with its fundamentals, don’t waste your dollars.
Not knowing when to buy or sell your holdings.
It takes knowledge and experience to know when you should offload or buy stocks. Some investors panic at the first sign of a market downturn and sell their stocks at a loss while others wait too long before selling that their holdings have become worthless. You need to develop an ear for these things and be able to find relationships in social, political and economic events with your stock’s holdings so you don’t buy or sell prematurely or too late.
Not investing for the long-term
Investing in the stock market is generally best reserved for those who have long-term goals, like retirement. Because of the volatility of the market, you are less likely to meet your short-term financial goals if you put your money in the stock market. When you have a long-term investment view, however, you are more likely to reap more earnings.
Not relying on an advisor to help you manage your portfolio
The financial world can change quickly. If you are working in an industry not even remotely related to the world of stocks, bonds and mutual funds, it would be virtually impossible for you to keep up with the latest developments that would affect your investments. Researching, tracking and making investment decisions all take time and the experience that only someone who is immersed in the matter day in and day out can provide.
If you don’t have time to read and do the due research to manage your portfolio well, it would be foolish not to seek help. You will have to pay a professional for the services he offers but you can be assured that someone will be there to manage your portfolio for you. Of course, this does not mean that you should just leave your advisor to do what he wishes with your portfolio. You should also educate yourself about the world of investments so that you can still stay on top of your retirement plan.
No related posts.
No related posts.