Diversification: How Diversified Should My Investments Be?
How many investments should I have in my portfolio?
Your portfolio doesn’t have to be complex to be effective! Today, the Fearless Advisor demystifies diversification and explains just how diversified to be.
Full Transcript of video
Hey friends, the Fearless Advisor here. Today I am going to discuss how diversified your investment portfolio should be.
Diversification, a term often misunderstood
Diversification is a word that is thrown around in the investment world like promises in a political campaign. Based on my conversation with many investors, the meaning or purpose of diversification is not widely understood. For example, some investors believe diversification is achieved by having accounts at different firms.
Diversification in your investments
is a mitigation strategy against
What is unsystematic risk?
Diversification in your investments is a mitigation strategy against unsystematic risk. Unsystematic risk is the potential negative impact on a specific company or industry due to competitors, regulatory changes, management changes, or product recalls. In other words, these are changes that do not impact the entire economy.
Owning a stock is having ownership in a company.
At a high level, we can look at categories or asset classes. Some common asset classes include US large companies, US small companies, developed international companies, emerging markets, real estate, and bonds. The first five classes I mentioned include having ownership in a company or equity. Owning a stock is having ownership in a company.
With a bond, you are loaning money to a company or municipality.
The last category, bonds, is different where you are loaning your money to a company or municipality. In return, the company or municipality will pay you interest. The interest you are paid is correlated to the market interest rates and the financial stability of the company or municipality.
Diversification: Spreading your risk while increasing the value of your investments over time
By owning investments across these different categories or asset classes an investor can spread the risk of losing their investment while also increasing the value of their investment over time. A popular way to invest across these asset classes by using mutual funds and exchange traded funds or ETF’s. These investment vehicles can include hundreds of individual stocks and bonds. These are popular for investors who value diversification and do not want to handpick hundreds of stocks and bonds.
Why we build portfolios at the household level
Now back to our question of how diversified your portfolio needs to be. In short, we prefer to build investment portfolios at the household level versus the account level. Portfolios at the account level yield the same asset class investments in every account. This can be confusing for investors who begin comparing which of their accounts are outperforming the others. Since all of accounts are your money, why should they compete with one another?
Our approach is to set aside the “confuse and conquer” method and approach all your money as the same portfolio. This allows less investments to be used across all your accounts, which yields shorter statements and fewer trading fees. Additionally, we can place investments that could have a negative impact on your taxes in your tax-advantaged accounts.
Your portfolio does not have to be complex to be effective.
In summary, c is about minimizing risk specific to an industry or company. Your portfolio can be simplified by investing across all your accounts as if it is one account. You may have all your bond and real estate holdings in your traditional IRA. Your small cap or small company holdings may be in your taxable accounts as they little to no dividends. Your portfolio does not have to be complex to be effective.
The key is your Investment Policy Statement.
As I have mentioned before, this all begins with your investment policy statement. Once you decide how you are comfortable investing your money to help achieve financial freedom, then you can create your portfolio of investments across all your accounts.
If you need assistance or have questions in this area, the team here at F5 Financial Planning would be happy to support your family. Feel free to reach out to us at F5 Financial Planning. Thanks for joining us!
Photo credit: F5 Financial
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