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.
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
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.
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.
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.