Syndicate
| Why should we diversify our Investments? |
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Why diversify? Because foresight isn't 20/20. Vanguard has a insightful article on diversification Sometimes, it's possible to have too much of a good thing. That's especially true when strong performance in a particular market sector causes one part of your investment portfolio to bulge while other parts shrink or grow only modestly. "The less diversified you are, the more pain your portfolio will feel" In such situations, instinct may tell you to celebrate your good fortune and leave your portfolio as is—or even to load up on the investment that's doing well. But according to Donald G. Bennyhoff, CFA, an analyst in Vanguard Investment Counseling & Research, in most cases a smarter approach is to take a close look at your long-term investment strategy and take steps to restore your portfolio's diversification. Protect yourself by learning from the past Many investors don't want to worry about diversification when they're enjoying a stock market run-up, such as the one we saw in the first half of 2007. But letting one part of your holdings swell disproportionately can be risky. You never know when the current Wall Street darling will fall out of favor, turning your outsized gains into outsized losses. Any investor who poured money into technology-focused stocks or mutual funds in the late 1990s can testify to the dangers of tilting a portfolio heavily toward one type of investment. And even though many of the scars of the dot-com meltdown have healed, it's important not to lose sight of the lessons from that painful period. A key investment lesson of the last decade is that no one type of investment should have too much—or too little—weight in your portfolio. For many investors, the harm caused by the collapse of technology, media, and telecommunications stocks was compounded by a lack of portfolio diversification. Specifically, many people had too little invested in the relative underperformers of the time, particularly value, small-capitalization, international, and REIT stocks—the very areas that have outperformed since 2000. "The reason you diversify," Mr. Bennyhoff said, "is no one possesses 20/20 foresight." Use an investment strategy to avoid drifting With the financial media always full of ads touting recent performance, Mr. Bennyhoff acknowledged, you might be tempted to drift away from a more diversified portfolio. And when temptation wins, the culprit is typically the lack of a comprehensive investment strategy. Key points * A broadly diversified portfolio should give you at least some exposure to the markets' best performers—and some protection from the worst ones—at any given time. * A comprehensive strategy can keep you from overemphasizing recent performance. * You don't need a large number of mutual funds to be well-diversified. Investors without a strategy to guide their choices tend to collect mutual funds based solely on the latest performance figures, Mr. Bennyhoff said. Taking this fragmented approach may lead you to invest excessively in parts of the market that have outperformed recently at the expense of the underperforming areas. In doing so, you might accumulate a lot of funds, but you could still lack adequate diversification because those funds are likely to have overlapping holdings. "An investment strategy can serve as your emotional anchor and help you feel more confident about your choices," Mr. Bennyhoff said, "because you know you have a well-balanced and well-thought-out plan." Developing your plan A trusted financial advisor can help you devise an investment strategy, but you can also create one on your own. One good way to start is by completing Vanguard's investor questionnaire. Once you're finished, you'll get a suggested mix of mutual funds tailored to your circumstances. Mr. Bennyhoff pointed out that you don't need many different investments to achieve excellent diversification. A few broadly based index funds or balanced funds (which invest in both stocks and bonds) can provide the appropriate level. "Sometimes the best solutions are the simplest solutions," he said. Of course, investment diversification will never eliminate your risk of loss, nor will it guarantee a profit in a declining market. But it should reduce the chance that you'll suffer disproportionate losses if one particular high-flying sector suddenly descends to earth. And owning a portfolio with exposure to all key market components should give you at least some participation in whatever sectors are performing best at a given time. Don't lose your balance Once you've established a diversified portfolio, you'll have to make sure you don't lose the balance you've worked to create. That will mean periodic rebalancing—shifting money from one type of investment to another—to ensure that you continue to hold the mix of stock, bond, and short-term investments that you deem appropriate for yourself. Rebalancing will result in taking some money away from the top performer of the moment. While that can be emotionally difficult, such investment discipline will help prevent you from becoming too heavily weighted in one area. "Diversification is the cornerstone of good investment practice, and rebalancing can be a way to make sure you achieve or maintain diversification," Mr. Bennyhoff said. "Investors, of course, want to buy low and sell high, and that is what rebalancing can help you do." Notes * Prices of small-cap stocks often fluctuate more than those of large-company stocks. Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility. * Past performance is not a guarantee of future results. * Mutual funds, like all investments, are subject to risk. Investments in bond funds are subject to interest rate, credit, and inflation risk. * Foreign investing involves additional risks, including currency fluctuations and political uncertainty. * Diversification does not ensure a profit or protect against a loss in a declining market. |
