Why Does a Diversified Portfolio Matter?

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Why does a diversified portfolio matter?  Put simply; it helps reduce the risk that you’re taking with your investments.  You’ve probably heard the saying, “Don’t put all of your eggs in one basket.”  That saying is speaking directly about diversification.

What Does a Diversified Portfolio Look Like?

Let’s say that you have $10,000 to invest, and you’ve decided that you want to invest in electric vehicles.  Investing in electric vehicles could mean a lot of things.  It could mean buying shares of Tesla.  The price of Tesla shares is notoriously volatile.  If you invest $10,000 in Tesla and the following day, the market price is up 3%. Then you have a nice $300 gain practically overnight. Although, if the market price of Tesla is down 3% the day after you invest, then you lose $300 practically overnight.

Diversifying Your Investments

Suppose now, rather than investing the entire $10,000 in Tesla, you invest half in Tesla and half in another car company. They also happen to make electric vehicles but have other products and do not have a polarizing and vocal CEO.  The second car company also has a stock price that tends to be less volatile. Potentially because it also has other products and does not have a vocal and polarizing CEO.  On the day after you purchase your shares, Tesla shares go down 3%, and the shares in the other company go up a modest .5%.  In this case, your portfolio would be down $250.  If Tesla shares were up 3% and the second auto company was down .5%, then your portfolio would be up $250.  Your potential gain was reduced, but so was your potential loss.

“Either way, if something happens that affects the auto industry as a whole, your portfolio is likely to decline in value, and neither stock would likely reduce the effect.”

Kellly Ennis – Financial Advisor & Founder of Infinity Financial Strategies
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Now assume that you’ve decided that you also want to invest in something that everyone needs. You choose a company that makes toilet paper (we all learned a lesson during the pandemic) and other products that are considered consumer staples.  Allowing that you split your $10,000 evenly between each of the three companies.  If the consumer staple company has many products and many ways to earn money, there’s a good chance that its stock price doesn’t move too wildly.  Many consumer staple companies have pretty steady stock prices.   

Having this stock in your portfolio can help you have a steady base in your portfolio.  Think of it as ballast in a ship.  It helps mitigate the ups and downs when the ship hits large waves.  This doesn’t mean that the stock price doesn’t go up and down. It just doesn’t usually move as drastically as the more volatile stocks.  This helps reduce the risk in your portfolio because it isn’t particularly volatile. It also isn’t likely to move in lockstep with auto industry stocks.

The Long Haul of Diversified Portfolios

Over the long haul, the market tends to go up.  The problem is that we don’t know how long the long haul has to be.  There will be times when the market is down even though the long trend is upward.  If we could stay invested for “the long haul” and our investments could roughly reflect “the market,” then we should expect investment gains over a long period of time.  It will take quite a few positions in a portfolio to roughly reflect the entire “market.”  There are stocks for roughly 2800 companies being traded on the New York Stock Exchange alone.  That doesn’t include NASDAQ and other exchanges.

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Take Advantage of Market Tendencies

If we can spread out the risk in an investment portfolio, we could potentially have stocks that tend to move in opposite directions.  We could add in bonds, which frequently (but not always) move in the opposite direction to stocks.  And bonds give an additional income source that is not dependent on the stock price. Which is another form of a diversified portfolio.  In addition, we should consider international stocks, both in developed markets and emerging markets.  Business cycles often occur with different timing in other countries. This means some economies will be in a growth period while others may be plateauing or even in a recession.   Portfolios with a good level of diversification would be able to rely on the market’s upward trend. This would then drastically reduce the risk at the same time.

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Diversified Portfolios Matter

If the CEO of Tesla makes a comment online that causes the stock price to decline precipitously, and your entire portfolio is invested in Tesla, the value of your portfolio will also decline precipitously.  To be fair, the reverse is true as well.  If the CEO of Tesla makes a brilliant comment or the company exceeds its target number of vehicle deliveries, causing the stock price to climb steeply, then the value of your portfolio would climb steeply as well.  The question is, can you stomach these wild swings?  Holding shares of multiple companies and investments with differing characteristics can reduce the wild swings in your portfolio value.

In short, diversified portfolios matter a lot when reviewing the full picture of your financial health and portfolio health.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

Essential Household Savings Accounts & Why You Need Them

Rainy Day Fund

A rainy day fund is different from an emergency fund–but it is still incredibly helpful for your peace of mind.

A rainy day fund is used for those relatively small and somewhat expected expenses that happen, but you can’t necessarily count on the timing. Imagine that your everyday life is a series of sunny days where you go about your daily life following your routine. Rainy days happen now and then and may disrupt your routine. Sometimes the disruption is welcome; sometimes, it isn’t.

Here are some examples of when you might use your rainy day fund.

Depending on your age and stage of life, you probably find that certain events happen in clusters. Weddings, births, graduations–etc. You know that these events may be coming, but you don’t know when. Travel for these events can be expensive depending on when and where they are. And then there’s the cost of gifts. These would be appropriate expenses for the rainy day fund.

Let’s say you have children, and they are on school break. And, you literally have a rainy day–or worse, a string of rainy days. This is when you dip into the rainy day fund and plan an event. It could be a short trip, an educational experience, or just rain boots and raincoats so you can all go out and play in the rain.

Other examples of uses for rainy day funds would be medical co-pays or coinsurance payments and veterinary bills for regular checkups. You might also use the fund for the replacement or repair of small electronic devices, sports equipment, minor car repairs, and home maintenance expenses.

A rainy day fund differs from your emergency fund. Emergency funds are used to help cover large, unexpected expenses like major car repairs, major home repairs or large medical bills. The rainy day fund is used for smaller expenses that you know you are likely to incur, but you don’t know the timing, and you don’t know exactly how much they will be.

So, how much should you keep in your rainy day fund? As usual, with financial questions, it depends. If you have a large family, including your pets, then you’ll want to add more to your rainy day fund to help with those insurance co-pays and vet bills. If you and your household depend on electronic devices(don’t we all?), then you’ll want to add more to your rainy day fund as well. Take a look at what could happen in the next year to help you determine an amount. How old are your cell phones? How likely is it that you’ll need to replace them this year? How about iPads and other devices? What about small home appliances like coffee makers and toaster ovens/air fryers/etc., that you depend on? How much is the deductible on your car insurance? This is the amount that will come out of your pocket if there is an event involving your car. How about the kid’s activity levels? Will their activities likely lead to expenses like new sports equipment (or medical co-pays)?

The rainy day fund, like the emergency fund, helps with peace of mind. You can design your spending plan and account for all of the regular expenses.

However, everyone experiences unplanned–though

not necessarily unexpected–expenses from time to time. Your rainy day fund can help you cover those expenses without derailing the rest of your financial plan.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

BENEFITS TO HIGHER INTEREST RATES

By now, you’ve undoubtedly heard that “the Fed” has been raising interest rates to rein in inflation. Interest rates are an essential part of our economy, and their impact can be felt by nearly everyone who participates in financial activities. The federal reserve raises interest rates to restrict access to funds and hopefully slow down the rate of increase of prices, including wages, in the economy. While this sounds like an awful idea if you are a borrower or have used access to cheap money to grow your business, higher interest rates can positively affect savers and lenders. If you are a saver, higher interest rates mean you can earn more money on your savings. This can be really helpful if you are saving for a specific goal, such as buying a house, starting a business, or saving for retirement. With higher interest rates, your savings will grow at a faster rate, allowing you to reach your financial goals sooner. Another advantage of higher interest rates for savers is that they can help to combat inflation. Inflation is the rise in the cost of goods and services over time, and it can erode the value of your savings. In other words, if the prices of the goods you buy rise faster than the value of your savings, your savings can’t buy as many goods. However, if you are earning a higher interest rate on your savings, you can offset the effects of inflation and maintain the purchasing power of your money. For lenders, higher interest rates mean that they can earn more money on the loans they provide. This can be particularly beneficial for banks and other financial institutions that make a significant portion of their revenue from interest on loans. Higher interest rates can also encourage more lending, as lenders are more likely to provide loans when they can earn a higher return on their investment. And, when you purchase a bond, whether a government bond or corporate bond, you also become a lender and can benefit from higher interest rates. Retirees and others who live on fixed incomes are often savers and lenders—a large part of their income is often the interest generated from savings deposits and bond interest. After nearly a decade of extremely low interest rates, these new higher interest rates are a real boon to those living on fixed incomes. Another advantage of higher interest rates for lenders is that they can help to stabilize the economy.  When interest rates are low, borrowing becomes cheaper, and consumers and businesses are more likely to take on debt. However, this can lead to an increase in inflation and a potential economic bubble, and in some cases, poor management decisions. Low interest rates can allow a company which is either poorly run or may not have an economically feasible business model to continue operations simply by borrowing cheap money. By raising interest rates, lenders can discourage excessive borrowing and prevent an economic crisis. Higher interest rates will have a different effect on savers and lenders versus borrowers. Savers can earn more money on their savings, combat inflation, and reach their financial goals faster. Lenders can earn more money on loans, stabilize the economy, and prevent potential economic crises. While borrowers may have to curtail spending in order to accommodate the higher cost associated with borrowing. While there may be some drawbacks to higher interest rates, the benefits for savers and lenders are significant.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

IMPACT OF HIGHER INTEREST RATES

While higher interest rates can be beneficial for savers and lenders, as we discussed in our last post, there are also several drawbacks to consider. In this blog post, we will explore some of the potential disadvantages of higher interest rates.

One of the most significant impacts of higher interest rates is that they can lead to increased borrowing costs for consumers and businesses. When interest rates rise, it becomes more expensive to borrow money, which can reduce consumer spending and business investment. This can lead to decreased economic growth, as businesses are less likely to expand and hire new employees. In fact, the employment numbers and wage levels are key economic indicators the Federal Reserve is using to determine when and the degree to which they should raise rates. 

Higher interest rates can also have a negative impact on the housing market. When interest rates are high, fewer people can afford to buy homes, which can lead to a decrease in demand and a drop in housing prices. This can be particularly problematic for homeowners who are looking to sell their homes for those who are in the process of buying a home. In some cases, it leads to consumers feeling “trapped” in their current homes because they currently have low fixed mortgage rates. Because mortgage rates are so much higher than they were just a few years ago, taking out a loan of the same size as the original loan to buy a new house can lead to a drastically higher mortgage payment.

Another potential drawback of higher interest rates is that they can lead to a decrease in the stock market. When interest rates rise, investors may sell their stocks and invest in safer, fixed-income securities such as bonds. This can cause a decrease in demand for stocks, which can lead to a decrease in stock prices. In addition, higher interest rates increase the price that businesses pay to borrow. Businesses that rely on cheap money (low-interest rates for borrowing), they may be unable to sustain the growth that they’ve had. And in some cases, a company may not be able to continue operations if the money it borrowed was subject to floating or variable interest rates and the payments have now simply become too large for the company to continue making payments.

Higher interest rates can also lead to an increase in the value of the currency. When interest rates rise, foreign investors may be attracted to invest in the country, which can cause an increase in the demand for the currency. While this may seem like a positive outcome, it can also make exports more expensive, which can harm businesses that rely on international trade.

Finally, higher interest rates can lead to an increase in the national debt. When interest rates rise, it becomes more expensive for the government to borrow money, which can lead to an increase in the national debt. This can have long-term consequences for the country’s financial health and can lead to a decrease in government spending on programs, including healthcare and education.

While higher interest rates can have benefits for savers and lenders, they also have several drawbacks to consider. These include increased borrowing costs for consumers and businesses, a negative impact on the housing market, a decrease in the stock market, an increase in the value of the currency, and an increase in the national debt. When considering the impact of higher interest rates, it is important to weigh both the potential benefits and drawbacks before making any financial decisions.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.

INTEREST RATES AND ECONOMIC CYCLES – WHAT’S IN IT FOR YOU?

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Interest rates and economic cycles–What’s in it for you? Economic cycles are characterized by alternating periods of expansion and contraction in the economy. These economic cycles can have an impact on interest rates, and, in many cases, the level of interest rates affects economic cycles. Right now, the federal reserve and other central banks have been raising interest rates in order to increase the cost of borrowing and hopefully slow down an overheating economy. As we discussed in our last two blog posts, there are benefits and drawbacks to individual consumers and businesses of these higher interest rates. Today, we’re going to look at how you, as a consumer, can set yourself up to take advantage of both high and low-interest rates. Not too long ago, interest rates were low–very low. If you purchased a home with a fixed-rate mortgage or perhaps refinanced a fixed-rate mortgage during this period, you might have borrowed at rates around 3%. Now, you can get 4% on your money just by leaving it in a savings account. And, after a year when the S&P 500 dropped about 20%, a 4% return sounds lovely. During those years of low-interest rates, finding places to get a decent return on your money with relatively low risk was difficult. When investing, we look for an appropriate risk-adjusted return; in other words, we expect a higher return if we take on more risk. Interest rates were so low that many savers became investors simply because they couldn’t get a decent return on their money by saving and lending. They had to take on more risk to get a decent return. And fortunately for them, we experienced the longest bull market in history from 2009-2020. With higher interest rates, you have to do more of a balancing act between investing in equities like stocks or lending like purchasing bonds or other debt instruments. In an ideal situation, you would have funds to deploy in each case as soon as the balance shifted such that your comfort level (your risk tolerance) could be met and your desired level of return could be achieved. However, we don’t have crystal balls and don’t know if any given economic event is a blip or the beginning of a new trend. As interest rates have increased over the last year, we’ve never known if we have already hit the top. If we’re at the top of the curve, then, as a lender or saver, you would want to lock in return for as long as you can.
On the other hand, if you lock in and then interest rates rise again the following week, you may be kicking yourself. Or, if you recognized that mortgage rates were at their lowest in 2020, you could have locked in a nice, low cost of borrowing for 30 years. At the same time, if you believe that we’re at the top of the curve, you also have to think about how long you think interest rates will be high. If you believe that interest rates will start dropping in the near future, then you may want to start investing again on the theory that easier money conditions will allow for accelerated business growth. The point here is that it is important to consider how economic cycles affect your individual financial situation. The “set it and forget it” method of financial planning may look like it works out for some folks. And, perhaps from a behavioral economic perspective, it has worked i.e.-they didn’t withdraw from their 401k because they weren’t thinking about their 401k. But, with a little attention, they may have been able to either reduce the risk in their portfolio or increase the return. Borrowing when the cost of borrowing is low–such as taking out or refinancing a mortgage–and lending when interest rates are high–such as purchasing treasuries and other bonds–is one method of taking advantage of the interest rates as we go through economic cycles.
Setting yourself up to make the most of interest rate changes is just one strategy you can use to reach your financial goals. Increasing or decreasing interest rates isn’t bad or good without context. It does come down to how you take advantage of them.

This article is intended to be educational and thought-provoking rather than financial advice.  When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals.  During our financial planning process, we examine these factors and many others to determine appropriate financial strategies for YOU.