What are the benefits of portfolio diversification?
If you concentrate too much money in one asset class, such as stocks, the risk of losing is increased, even when markets are strong. Diversifying your portfolio–investing in a broad combination of stocks, bonds, cash, and other assets–doesn’t guarantee a profit but may help reduce the risk of losses.
Multiple baskets are best
The concept of diversification can be easily explained with the well-worn cliché, Don’t put all your eggs in one basket.
To apply this to your financial portfolio, your investments can be diversified by including broad combinations of stocks, bonds, cash, real estate, and other assets. Although diversification doesn't guarantee a profit, the goal is to reduce the risk of significant losses by spreading out your investments. And simply put, if you concentrate too much money in one asset class, such as stocks, the risk of losing is increased, even when the markets may be strong.
If your assets, such as stocks, are concentrated in just a few of the 11 stock market sectors (e.g., healthcare, energy, utilities), there’s an increased risk of financial loss if one or even a few of those categories substantially decline†.
In addition to avoiding being too heavily invested in certain sectors, it’s advisable to have various asset classes in your portfolio beyond stocks, such as bonds and real estate, commodities, or cash, with varying levels of risk. U.S. government bonds, for example, are considered a relatively low-risk investment, while international stocks allow you to diversify outside the U.S. You may also want to consider your investment time horizon: As you approach retirement, you may want to reduce risk even more.
A diverse portfolio might benefit from variety of investment assets listed below, each with its own unique risks and rewards. A Huntington financial advisor can help determine what combination works well for you.
- Mutual Funds
- Individual Stocks
- Separately Managed Investment Accounts
- Individual Bonds/Fixed Income Securities
- Cash and short-term equivalents, such as certificates of deposit or money market accounts
- Exchange Traded Funds
- Real estate
- Alternative Investment Structures
Some people follow the 5% rule, which suggests that the maximum investment one should have in one security is 5%. This may be difficult to track because of an investor’s unfamiliarity with their portfolio, and because some mutual funds could create an overlap that exceeds 5%‡. Because mutual funds in particular can include the same stock or bond, it may require a little effort to analyze your holdings and consider removing that overlap where and how appropriate.
Your financial advisor may also be able to assist, and whether they review and rebalance your portfolio or you do, it should be an ongoing exercise at least once a year.
Beware the tempting trend
It seems like the stock market is always facing crosscurrents that may or may not spin off a trend. And if it does, how long the trend continues is anyone’s guess, so it’s important to be patient.
Maintaining a diverse portfolio may help avoid investing too heavily in that 'sure thing.' Meme stocks are a good example and thought to have been fueled by day traders during the pandemic. For any number of reasons (and sometimes with little reason), a stock’s value begins to increase, investors focus on the stock that then goes viral, and quickly its price hits surprising highs.
To reduce your exposure to risk, stay patient and diversified, and consider working with your Huntington financial advisor.
Examples of meme stocks and why you may want to avoid them
AMC Entertainment was facing bankruptcy in early 2021 with a stock price of $1.91. For various reasons, few to do with future performance, it got the attention of the Reddit community and the stock price exceeded $70 per share by July 2021. By January 2023, though, its price was less than $4 per share.
In April of 2020, GameStop’s stock price was $0.70 per share, but by January 2021, it was more than $80 per share thanks to similar support from social media users. In January of 2023, Game Stop’s share price had sunk to $16.22.
† Hayes, Adam. Feb. 23, 2022. Sector Breakdown Definition and Stock Market Use. Investopedia. Accessed May 15, 2023.
‡ Gordon, Jason. April 17, 2022. Five Percent Rule – Explained. The Business Professor. Accessed May 15, 2023.
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