The first quarter of 2011 was a turbulent one, as markets rose and fell with world events and increasing costs for basic raw.
Some experts feel this volatility, an unwelcome guest for many investors, will stay the year. To make the visit more comfortable, advisors recommend turning to the tried-and-true tactic of diversification.
The slide into Recession - and the rocky road out - have taught investors many sobering lessons, but the financial advisors who’ve been preaching diversification for years hope investors have finally gotten religion.
A diverse portfolio can help protect the average investor from the market’s ups and downs. Diversification spreads risk over a number of investments that typically include an array of stocks and bonds, some cash and perhaps alternative investments, such as a gold exchange traded fund. The mix of investments varies with an investor’s risk tolerance and time-frame, but the guiding logic remains the same. As your mother might have told you, “Don’t put all your eggs in one basket.”
Diversification protects investors – who can be their own worst enemies – from common pitfalls such as market timing. History shows that retail investors tend to jump into a hot market just as it peaks. Instead of reaping gains, they arrive just in time for the fall. An appropriate mix of investments also prevents overweighting, investing too heavily in any one product – such as company stock. Overweighted portfolios can tank along with their key asset. The strategy also provides peace of mind. When an investors’ stocks lose value, other investments can rally and offset those losses.
Diversification is an important consideration for affluent investors making financial decisions. The strategy takes on more significance with wealthier investors, Spectrem Group research shows. A little more than three-fourths of Mass Affluent investors consider diversity of investments to be a key factor, while 88 percent of Millionaire and 85 percent of Ultra High Net Worth Investors rank diversification as key.
(Spectrem defines wealth as net worth not including primary residence. The Mass Affluent have a net worth of $100,000 to $1 million; Millionaires, $1 million to $5 million; and the Ultra High Net Worth, $5 million to $25 million.)
Although the concept of diversification seems simple, even investors who say they are very knowledgeable about finances don’t always know how to carry out the strategy. One-fourth of people who said their financial knowledge was “very high” did not give the correct answer to a question about risk and diversification asked during a national survey conducted by the FINRA Investor Education Foundation. The respondents said investing in a single company stock was safer than investing in a stock mutual fund, which contains an array of investments. “The correct answer is no,” FINRA said in a statement.
Diversification allocates money to particular asset classes and subclasses. In the case of stocks, subclasses include market size – a large, mid-size or small company - and sector, such as technology or energy. Bond subclasses include issuers - government and corporate - or maturity date. Pooled investments, such as mutual funds and exchange traded funds, include a variety of underlying investments and can help build diversity, FINRA said.
“Diversification, with it emphasis on variety, allows you to manage nonsystematic risk by tapping into the potential strength of different subclasses, which, like the larger asset classes, tend to do better in some periods than in others,” FINRA said.