Building a Diversified Investment Portfolio for Long-Term Wealth Management
Investmentby Gregory M. Estes, Senior Portfolio and Relationship Manager
“It is the part of a wise man to keep himself today for tomorrow, and not to venture to put all his eggs in one basket.”
- Miguel de Cervantes, Don Quixote
The old adage above, shortened in today’s world to simply “Don’t put all your eggs in one basket,” has applications in many aspects of life. A business owner should not rely on a single supplier. A shopper should check prices at different stores before committing to a major purchase. Perhaps the biggest use of the phrase come in investing. An investor should not be overly concentrated in one stock or one asset class, because the effort to make great gains by concentrating all of one’s resources could lead to great losses. Thus, the concept of diversification, or a spreading of one’s eggs on many different baskets.
When a major event hits the news, it's natural to wonder how that could impact you and your investments. Should you be concerned, or is your portfolio prepared for unexpected changes? If you're still wondering whether or not to adjust your portfolio based on current events, speak with your investment advisor first, as they can help determine what may be best for addressing your long-term financial goals.
What is Diversification?
Diversification in the investment sense can be viewed from a few levels. First, by diversifying investments within an asset class – holdings more than one stock or bond- can lead to less concentration in any one company or sector. This notion can be extended to company size as well (small cap, mid cap, and large cap stocks). Second, by diversifying across investment styles to include by growth stocks and value stocks, one can reduce risks that are associated with specific investment strategies that perform better or worse in different market conditions. Third, by diversifying across asset classes with a long-term asset allocation plan, an investor can develop a long-term approach that reduces portfolio volatility which can occur in various bear and bull market cycles in the stock market.
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The Benefits of Diversifying Your Portfolio
As mentioned previously, reducing risk is one of the key reasons you might decide to diversify your portfolio. While risk can’t be eliminated entirely, diversifying your portfolio can help you manage your overall level of risk and minimize your chances of losing large sums of money over time. When you don’t diversify among your asset classes, you become even more exposed to market risk.
To go along with reducing risk, diversification also allows you to hedge your portfolio, which is an automatic benefit of refraining from putting all of your eggs in one basket. By investing in a variety of sectors, you even out your chances of getting positive and negative returns, as opposed to purely negative.
Capital preservation is another benefit of diversification. Instead of focusing exclusively on your rate of return, capital preservation is all about protecting the money you already have. Because diversification involves investing in a variety of stocks, bonds and mutual funds, it may make it easier to protect the wealth you’ve already saved and accumulated.
Diversification can also be thought of as an admission that as investors, we are not able to know the future. Markets ebb and flow. Stocks can have great years and very bad years. In one year, emerging markets may lead other asset classes, while in another year, perhaps commodities are the highest performer. That fact of the matter is that nobody can say with certainty which investment will lead in the future. The chart below illustrated this point:
Reading this asset quilt, each year is a column, asset categories are ranked in order from the highest performing at the top to the lowest performing at the bottom. From year to year, the rankings change, and some categories can swing wildly. For example, and investor that is heavily focused on commodities might have had a very good year in 2022 but suffered greatly in 2023. Implementing a diversified portfolio recognizes this reality and seeks to avoid the possible feast-or-famine involved with overly concentrated portfolios.
Recognizing that diversification is important, what can be done? One can make a plan, in consultation with their financial advisor, that tailors their specific needs- cash flows, risk tolerance, time horizon, etc- and incorporates them into a long-term target asset allocation. This will become the roadmap that can guide the investor in maintaining their portfolio over time. It can sometimes be tempting to concentrate a portfolio, particularly when one hears someone bragging about making high returns in a very risky stock. It is a part of human nature to want to make hay when the sun is shining. However, a portfolio that is built for the long-term through diversification can lead to peace of mind, knowing that when storm clouds gather, there is a plan in place to find shelter while still progressing towards long-term financial goals.
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