How to Diversify Your Investment Portfolio

A person explores diversifying their investment portfolio on their smart phone.

Last year’s meme-stock craze made for entertaining news coverage. Average citizens stuck at home because of the lingering pandemic, sticking it to elite hedge funds that were betting against struggling retail brands by investing in those same companies to boost their worth and teach Wall Street some humility.

Now, with pandemic restrictions largely lifted and the meme-stock buzz faded, shares in these same companies have plummeted by between 75 and 90 percent. If anyone had invested their life’s savings in these businesses when their stocks were soaring by triple-digit percentages, they would have nothing today.

The phenomenon demonstrates the danger of several concepts. The first is the high risk of speculative investing, which is essentially gambling and not to be confused with mainstream investing for purposes such as retirement or long-term returns.

It’s also an extreme example of the dangers of putting all your eggs in one basket. There’s a reason why one of the most popular pieces of investing advice is to diversify your portfolio. And the start of a new year is an ideal time to underscore that guidance, define diversification and some related terms and concepts.

Diversification refers to the practice of spreading your investments across different types of assets to limit your exposure to the risks inherent in any one of those asset categories. This helps reduce the volatility of your investment portfolio over time.

So now, we first need to explain what these different asset types are and what risks they typically pose. For this, we turn to BluPeak Investment Advisor James Vasquez, who gives informational presentations as part of our focus on financial education and wellness for everyday people. In a webinar he recently led on the basics of investing, James began by explaining three of the most common places where one can put their investment dollars: in stocks, bonds and cash equivalents.

These are also known as “asset classes,” and here’s how James describes each of them:

Stocks

Stocks represent a percentage of ownership, or equity, in a corporation. In other words, if a company is divided into a million shares, and you buy one share, you would own one-millionth of that company. There are two ways to make money on stocks: by receiving dividend payments from the company, and by selling the stock for more than you bought it for.

Most stocks are common stocks, and with these, the dividend payments are not fixed, and the company is not required to pay them—although many do. The other type of stock is preferred stock, and with these, regular dividend payments are usually guaranteed. An important difference between common and preferred stock is that the former gives you the right to vote for the company’s board-of-director candidates, whereas preferred stock doesn’t.

Another way to look at a stock is growth versus value. People who invest in growth stocks expect significant increase in the company’s value, thereby increasing the value of their shares. They’re not concerned with getting any type of money back through dividends immediately. The main goal of a growth stock is to buy it at a certain price and sell it at a higher price in the future.

Alternatively, when you invest in value stock, you’re not expecting the value of that company to increase dramatically. But you do expect to participate in a share of the profits they pay to their investors on an annual basis.

James says, historically, long-term stocks have provided the greatest return. However, there are no guarantees: One day, your stock may be worth more than what you paid for it—the next, less. The price of a stock is typically influenced by the performance of the company and general economic conditions. But it can also be influenced by investors’ expectations and emotions.

Bonds

While stocks are an ownership investment, bonds are a lending investment. You give the bond issuer money, and in most cases, they pay you interest in return—just like you pay interest to a creditor. Generally, you receive your principal at maturity of the bond and the interest periodically while you are holding the bond. With bonds, you can make money both from interest payments and by purchasing the bond at less than its principal value, although bonds sometimes trade at or higher than that.

There are three basic types of bonds: corporate bonds, municipal bonds, and federally issued bonds.

Corporate bonds are issued by non-government entities that are trying to raise money, and they can vary considerably in length, yield and risk. Companies that are considered less stable are generally going to pay higher interest. But, as James explains, there’s always a risk that the company could default on the debt, so the higher return comes with higher risk.

Municipal bonds are issued by state and local governments. These are generally considered a safer than corporate bonds. Almost every local and state government needs to issue bonds from time to time—often, to pay for major infrastructure projects. You lend them the money, and they pay you interest.

Meanwhile, federally issued bonds are considered one of the safest forms of investment in the world, because they’re backed by the U.S. government. Federal bonds are also known as treasuries, or “T-bills” for short. They are considered risk-free, and are purchased by governments around the globe as a safe place to put their countries’ money.

Cash Equivalents

The third and final type of investment most people have in their portfolio are “cash equivalents.”

This type of asset is called that because it can be readily converted into cash. They’re also known as “liquid” assets, because you can easily unload them when you need the money. Because they’re safe, and often guaranteed, cash equivalents provide a relatively low return.

Examples include savings accounts and certificates of deposit (CDs). Generally, with these, you deposit your money in a financial institution and are required to leave it there for the term of the certificate—or pay an early-withdrawal penalty. Certificates are also insured, so they’re safe, but generally have a higher interest rate than savings or checking accounts.

Asset Allocation

Next, you need to decide how to divide your investment dollars among those different types of assets. Along with that, it’s crucial that you understand the two major risks that all investors face.

The first is that you could lose some or all of the money you invest. So it’s never a good idea to invest money that you need to cover your daily living expenses. That’s best kept in your checking or savings account so you can easily access it.

The flipside of that risk is that your returns could be too low to achieve your goals. So, while the checking and savings accounts are great for those daily living expenses, the return is probably going to be too low to really be considered an “investment.”

Historically, stocks have provided the highest return, but present the most risk of losing your investment. If a company goes out of business, files for bankruptcy, or otherwise performs poorly, your stocks could be worthless.

When determining what percentage of your savings will go into each type of investment class, James says to consider the timeframe. For short-term goals, because you will be using the money soon, making sure you don’t lose money is a much bigger concern than low return. Therefore, putting most or all of the savings in cash equivalents might be your best strategy.

For long-term goals – and to a lesser extent, mid-term goals – return is a definite concern. By investing in vehicles that provide a higher return, you don’t have to contribute as much to achieve your goals. Plus, losing money is less of an issue because of the longer timeframe. As we’ve all seen in the not-too-distant past, the stock market may dip for a few months, or even years. But history shows us that, over time, the market rises.

Risk tolerance and diversification

In his “Basics of Investing” presentation, James illustrated a conservative investing approach by giving the example of someone putting 40% of their retirement fund in stocks, 40% in bonds and 20% in cash equivalents.

In contrast, someone with an aggressive investment strategy may put 80% of their retirement fund in stocks, 10% in bonds and 10% in cash equivalents.

However, even if you’re a more aggressive investor, you should still consider ways to minimize your risk. One way to do this is to diversify, by investing in a mix of stocks, bonds and cash equivalents. That way, if one sector is down, it can be balanced by others that perhaps are doing better.

It’s also a good idea to diversify within each type of investment class. For example, you can purchase stocks from manufacturing companies, technology-oriented business, and financial-services firms.

A simple way to get diversity in your portfolio is to purchase shares in a mutual fund, which pools money from multiple investors to buy different stocks, bonds and/or cash equivalents. You buy shares in a mutual fund in basically the same way you buy individual stocks—it’s just that the mutual fund owns pieces of a lot of different companies or bonds of cash equivalents.

In general, the farther you are from retirement or other financial goal you’re pursuing, the more aggressive you can be. But as you get closer to retirement or to needing the money for your financial goal, you’ll likely want to gradually shift to more conservative investments so you can be more confident the money will be there when you need it.

Ready to speak with someone about your goals? Set up a no-obligation meeting with one of our friendly Investment Services team members and choose a time that work with your schedule.

Securities offered through Securities America, Inc., member FINRA/SIPC.  Financial Advice & Investment Advisory Services offered through PFG Advisors, a Registered Investment Advisor (RIA).  PFG Advisors, BluPeak Credit Union, BluPeak Investment Services and Securities America, Inc. are separate entities.

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