Behind “spend less than you earn,” the phrase “diversify your investments” has to be one of the most common pieces of personal finance advice.
But what exactly does it mean?
Are you supposed to mix up stocks and bonds? Invest in real estate as well as Bitcoin?
What are diversified investments?
As it turns out, diversifying your portfolio, or holding diversified investments, is pretty much what it sounds like.
It means not putting all your eggs in one basket, not investing all your money in the same “asset class” (not only stocks or only bonds, for example) or in the same sector (not only tech companies, for example).
Why is it important to diversify your investments?
No one can predict the future. You might think Google stocks will never go down, but you can’t know for sure.
“You’re going to want to spread your risk across multiple investments,” said Douglas A. Boneparth, a certified financial planner and the president of Bone Fide Wealth. “You don’t want to be in a position where one investment does poorly and your portfolio suffers dramatically.”
By having a wide range of investments, you protect yourself from dips in the market. If one investment loses value, then hopefully the others will keep your portfolio strong.
“When your goal is to grow your money over the long term, [diversification] helps smooth out your returns,” said Boneparth. “It helps aid in the process of growing consistently by, ideally, maximizing return and minimizing risk.”
The first step in diversifying investments
When it comes to diversifying your investments, Boneparth said the first step is to calculate your “risk tolerance,” or the amount of variability in returns you’re willing to absorb.
If you have a long time before retirement, for example, you’re probably willing to take bigger risks — since you have many years for your portfolio to bounce back.
To determine your risk tolerance, you can take an online quiz like this one from Rutgers University. At the end, it reveals your risk tolerance and suggests suitable investment vehicles.
When I took the quiz, it deemed my risk tolerance to be average/moderate and suggested the following options: convertible bonds, high-yield bond funds (or junk bonds), large-cap stocks and funds, S&P 500 and Wilshire 5000 stock index funds, and variable annuities invested in large-cap stock subaccounts.
Some examples of diversified investments
Everybody’s financial situation is unique — and chances are, if you took the quiz, your results would be different. But I can tell you how I plan to diversify my investments.
First off, I’m going to listen to legendary billionaire investor Warren Buffett and purchase an index fund, which holds a diverse array of stocks.
Buffett told CNBC that it “makes the most sense practically all of the time.” The index fund he recommended, an S&P 500 fund, is based on stocks from 500 major U.S. companies, so purchasing it means I’m spread across sectors.
Two more pieces of advice from Buffett: “Keep buying it through thick and thin, and especially through thin,” and make sure whatever fund you choose has low fees.
To further diversify my portfolio, here are a few other investments I’m considering:
- International index fund: for exposure to markets outside the U.S.
- Bond fund: for a low-risk, low-return investment
- Real estate: for something separate from the stock market, through either real estate investment trusts (REITs) or the purchase of a rental property
“No matter what your situation, [diversifying] means creating an investment mix based on your goals, risk tolerance, financial situation, and timeline and being diversified both among and within different types of stocks, bonds, and other investments,” according to Fidelity.
Based on your risk tolerance, Fidelity recommends the following “asset mixes.” (My moderate risk tolerance puts me in the “growth” category, so I feel like my plan is pretty solid.)
Image credit: Fidelity
Diversified investments are important for reducing risk
“Being diversified and sticking to your strategy when investing is the vast majority of the battle,” said Boneparth. “I feel like when people violate one of these two rules, that’s typically where bad things happen.”
So, make sure you diversify your portfolio to reduce risk and maximize your return.
If you don’t feel up to the task of diversifying your own investments, you can hire a certified financial planner or try an app like Betterment, which claims to offer a globally diversified mix of stocks and bonds.
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