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Diversify to Maximize Your Investing Profits

Owning the right mix of investments is a crucial, but often overlooked, part of reaching a successful outcome such as retirement.

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OWNING THE right mix of investments is a crucial, but often overlooked, part of reaching a successful outcome such as retirement.

Your portfolio must be tailored to your unique financial goals, time horizon and risk tolerance. If you take too much risk, in the form of owning too much stock, your portfolio may correct severely; the impacts for a retiree can be permanent.

On the other hand, not enough risk, in the form of too much cash or fixed income, could result in a return too low to fund retirement goals.

Understanding Balanced Investments

Rather than throwing together a randomly selected batch of securities and hoping they go up, investors should understand what allocation is right for their situation.

That typically begins by determining the correct mix of stocks, bonds and cash. In previous generations, the adage was: “Subtract your age from 100, and that is the percentage of stocks you should own.” Using that formula, a 40-year-old would own a portfolio containing 60% stocks and 40% in bonds and cash.

However, that method of determining an allocation is overly general and does not take into account the unique circumstances of any individual or household. A comprehensive financial plan is a far better way to make sure your money is invested in the best possible way for you.

But once you’ve determined your allocation, how do you know exactly what to invest in? For example, say your plan shows you are best served with a portfolio of 60% stocks and 40% bonds and cash. Should you just buy an exchange-traded fund that tracks the S&P 500 index, invest 35% in a fund tracking the Barclays Capital U.S. Aggregate Bond Index and put the remaining 5% in a money market fund?

Reasonable Allocation and Diversity

That approach might seem easy and reasonable, but it has serious drawbacks. The most glaring deficiency is lack of diversification.

The S&P 500 represents one asset class: large American stocks. If those stocks take a nosedive, you are completely at their mercy. If you held other equity asset classes, such as small U.S. stocks, international developed market and emerging market stocks along with some alternatives such as commodities or real estate investment trusts, you would likely be well-positioned to weather a downturn.

That’s because different asset classes behave differently; if large U.S. stocks tumble, it’s possible that emerging market stocks or commodities may perform better. That would offset your declines and smooth your return.

That’s also true on the bond side. The composition of the Barclays Capital U.S. Aggregate Bond Index consists of about 92% domestic bonds, so there again, your exposure is limited to one fixed-income asset class. Owning other short-term, high-quality bonds issued by international corporations and governments may help reduce your risk.

Choosing Stocks

One common investing mistake is picking single stocks. Sticking with the 60/40 illustration, it’s certainly possible to construct a portfolio consisting of 60% equities, but in the form of single stock along with bonds. In this example, the portfolio would include 35% in a fund tracking the Barclays Capital U.S. Aggregate Bond Index, 5% in a money market fund and 10% in each of the following stocks: Apple ( ticker: AAPL), Facebook (FB), Alphabet (GOOG, GOOGL), (AMZN), Berkshire Hathaway (BRK.A ,BRK.B) and JPMorgan & Chase Co. (JPM).

This portfolio would have a potential annual return of 5.25%, but at a high level of risk. Within the next six months, this portfolio is likely to have a potential return ranging from a gain of 18.77% to a loss of 13.53%. That gain sounds great, but for many people, that decline would be unsettling and might cause bad behaviors, like selling at low prices and locking in losses.

That allocation can be improved greatly, through diversification, to mitigate losses.

Balancing Portfolios that Produce

Instead of limiting yourself to single stocks and one fixed-income asset class, consider investing in a wider array of securities. Here is one possible asset-class allocation that also accomplishes the 60/40 mix:

  • A total U.S. stock market ETF: 42%.
  • A world stock market (ex-U.S.) ETF 15%.
  • An ultra short-term domestic bond ETF 12%.
  • A core domestic bond ETF 10%.
  • A short-term corporate bond ETF 10%.
  • An intermediate-term core bond ETF 6%.
  • A REIT ETF 3%.
  • Cash/money market 2%.

This portfolio has a potential annual return of 6.08%. Within the next six months, this portfolio has a likely potential return ranging from a gain of 16.03% to a loss of 9.95%. Notice the potential return was increased, while the potential maximum gain decreased slightly, and the potential maximum decline is now reduced significantly.

The above portfolios are for illustration purposes and are not recommendations. The key point is: Proper global and asset class diversification is crucial to a properly allocated portfolio. It’s not enough to simply invest in 60% stocks and 40% fixed income and call it a day. Broad diversification within any allocation, whether 60/40, 50/50, 70/30 or any other, is a proven way to smooth returns over time, and mitigate risk.

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