It doesn’t take psychic powers to become a successful investor. In fact, the better way to invest is by acknowledging the fact you can’t predict the future. The trick is diversification, which is the investment strategy of owning a mix of investments in your portfolio.
Generally, the more variety of investments you own, the more protected you are from significant losses, and the greater your chances for owning market winners.
As it happens, some long-term investors (namely, those saving and investing for retirement) may not know if their portfolio is properly diversified. Worse, they may believe it is, only to find out during a market crash that it’s not.
You may have chosen funds in your 401(k) long ago based on past performance, without fully understanding how they relate to each other. Or, perhaps, you created a portfolio with a broker who was more interested in earning commissions rather than managing your investment risk.
Fortunately, finding out if your portfolio is diversified is a simple process. Just grab your latest investment account statement and follow the action steps below.
Benefits of portfolio diversification
Before learning how, it’s important to understand why diversification matters.
There is always the risk of losing money in the market. That risk is highest if you invest all your money in one investment.
The strategy of investing in multiple asset classes and among many securities can help lower your overall investment risk – and help keep you from missing out on the investments producing positive investment returns.
That doesn’t mean never seeing a loss. But it does mean lower volatility. With a diversified portfolio, the highs and lows are evened out.
Now, let’s go through the different levels of diversification.
What asset classes do you own?
At the very top are asset classes. The most common asset classes are stocks, bonds and cash. However, you can further diversify with other asset classes, such as commodities and real estate.
How you divide your portfolio among asset classes – your asset allocation -- will greatly determine its performance. Research indicates asset allocation accounts for more than 90% of your portfolio’s returns over time.
The point is to own asset classes whose prices move independently of each other. For example, stocks and bonds.
Stocks are generally the main driver of portfolio returns, but also the main source of risk. Bonds can help limit the downside of stocks, as bonds often perform well in times stocks are down.
What asset allocation is right for you depends on personal factors such as your financial goals, age and attitudes toward risk. So, younger workers should have a greater allocation to stocks for their higher return potential. While those nearing retirement should gradually scale back risk by allocating more of their portfolio to lower-risk investments like bonds.
ACTION STEP: Look at the print statement or online dashboard of your investment account. Your overall asset allocation should be shown prominently. Often it is represented in a simple pie chart divided by asset class.
Hopefully, you see a balanced allocation of stocks and bonds aligned with your return needs and risk tolerance. What you don’t want to see is your account filled with a single asset class.
What kind of funds do you own?
A properly diversified portfolio is also diversified within each asset class. That generally means owning funds that hold many securities.
For simplicity’s sake, we’ll continue to look at the two most likely asset classes in your portfolio, stocks and bonds.
Stocks are categorized by a variety of company characteristics, including market capitalization, profits, share price, industry and geographic location. A stock mutual fund may be comprised of hundreds or thousands of stocks that exhibit one type of characteristic or a mixture of them. It is important to note that some stock types are riskier than others. The biggest companies in the U.S. are less risky than small companies in Asia.
Similarly, bonds fall under different categories, ranging from government and corporate to agency rating and country of origin. Bond funds also may hold one particular type or a mix of types. Risk too varies among bond types. A bond backed by the U.S. Treasury is safer than one offered by a company.
ACTION STEP: Your statement should list every fund within your account. Those funds should hold many securities of distinct types. You may own a handful of funds or a few that cover whole markets or sectors.
For example, your stock allocation may be comprised of one fund with large U.S. companies, one with small U.S. companies and one of international companies. What you don’t want to see is multiple funds with the same holdings.
If you cannot tell, you should have access to literature through your account custodian that explains the style and strategy of each fund in more detail. That information is also easily found online by searching by fund name. What amount you should have invested in each type of fund also depends on your personal situation.
What diversification is not
There are some common misconceptions of diversification. Simply put: The more funds you own does not mean more diversification.
A lot of funds overlap. They own the same securities, so their prices move in tandem. There is no point in owning five stock funds that have the same big-name tech companies, for instance. It is possible to be overdiversified, which can result in paying higher investment costs than necessary.
Additionally, diversification is not about holding an equal share of each type of asset class or fund. Since each type of investment has its own return and risk characteristics, those allocations are dictated by your personal return needs and risk tolerance.
What about target funds?
An increasingly popular 401(k) option is target date funds, which funds act like an autopilot investment. Each target date fund has a different year attached to it, with the objective being that you choose the year closest to your ideal retirement date. They are designed to start aggressive and then become more conservative over time as the target year gets closer.
While target date funds are convenient and better than choosing funds randomly, they do have drawbacks worth considering. Since they become conservative automatically, there is potential to miss out on growth opportunities. Eventually, a target date fund can even become too conservative for your needs.
When in doubt, consider getting a portfolio review from a financial adviser, who can help identify what asset allocation is most appropriate for you. It is a good idea to make that adviser a fiduciary. Advisers who follow the fiduciary standard must recommend investments that are in your best interest, not sell what comes with a generous commission.
Remember, your portfolio is only one source of income in retirement. Another important retirement pillar is Social Security. For help choosing the right Social Security strategy, download our free Guide to Social Security Benefits.