You've heard it before and you'll hear it again: diversification is important in your portfolio. But just what does that mean? Diversification can take on many forms. Do you know the different ways to diversify?
Diversification can be as simple as adding bonds to an all-stock portfolio. This adds a measure of stability to a portfolio. However, the 2008 Financial Crisis showed that just a stock and bond portfolio could perform poorly, too. Granted this was an unusual event.
You would have done better in the Crisis if you had held some cash in your portfolio. Cash may seem like a go-nowhere option, but it does offer stability. Plus, cash on hand allows some reserves for purchasing a good deal on an investment when it occurs.
Diversifying a portfolio goes even deeper than this though. Stocks can be diversified further. You can diversify further by having stocks of small-cap, mid-cap and large-cap companies. Dividend stocks are good for income generation.
International stocks offer a chance at non-correlating returns. In fact, international stocks can be divided by country or sector of the world. One popular option has become emerging market stocks. These are countries whose economies are growing rapidly. China, India and Brazil are the top emerging market economies.
Bonds can be further diversified into U.S. Treasuries, corporate bonds and municipal bonds. U.S. Treasuries are bonds issued by the United States Government. Corporates are issued by companies while municipals are issued by United States states or cities. Owning international bonds of a variety of countries are another diversification option.
Commodities have their place in a portfolio. Commodities are the raw materials used to build structures, heat or cool homes and feed us humans. They have a history of moving in opposite directions of stocks and bonds.
More diversification can be achieved by investing in real estate stocks. Many people can consider their selves already diversified into real estate by owning their own home. Real estate investment trusts (REITS) are another option.
Stocks can be further diversified into growth companies vs. value companies. Growth companies put profits back into growing the business. Value stocks often pay out dividends. They are also considered to be trading at a value below what they are worth.
So are you now confused? Are you wondering if all this diversification is possible, let alone worth it? Well, some diversification is definitely worth it. Stocks and bonds should be your core holdings. A little cash is good to have as well.
The easiest way to get good diversification is with an index fund. A good plan would be to have a stock index fund, a bond index fund and an international stock index fund. A small portion into a commodity or emerging market fund can be beneficial if you have the money.
Trying to diversify without index funds will cost you more. You pay much more in fees by having more than a few funds. These added expenses can eat at the extra return you would get by diversifying further.
So go ahead and diversify. Just try to keep it fairly simple. A little to a medium amount of diversification is a good thing. Too much and you risk overdiversification thereby diluting your returns and causing yourself stress.
May I recommend my ebook, Investing $10K in 2013