The Essentials: Diversification
Fill in the blank: I only like investing in_______. (Real estate, stocks, cryptocurrency, gold, etc.). I invested once and it didn’t end up well. I don’t trust this stuff. These are all common statements that I hear regularly, and they all typically translate to: I am uncomfortable with the risk.
Investing always involves risk and there are several ways to handle the amount of risk you take when investing your money. One of the most important concepts for managing risk is diversification. Diversification is the process of spreading your money among various types of investments so that you limit your exposure to the risk of any single investment. In this post, we will discuss why diversification is important for investment success.
Don’t put all your eggs in one basket
It is important to understand how the assets that you invest in relate to each other. If your investments are all correlated with one another, you may find yourself in a situation where your entire portfolio is moving in one direction. That may be great when it is going up, but when it is going down, it can really churn your stomach. By diversifying your investments among several asset classes that are less correlated, you can reduce volatility.
Keep enough money in cash
Often investors feel the most pain when they lose money that they need for expenses. It is important to keep enough money safe from volatility to cover your needs for at least 12 months. This way you won’t have to sell an investment while it is down just because you need the cash.
Know your time horizon for investing
It is important to set expectations for your investments from the beginning. You should diversify between investments that will meet your long-term goals and also investments that can provide for short-term needs.
We group investments (assets) into categories. These groups or classes are the components of building a portfolio. In my career, I have never met a financially successful individual who didn’t own various assets. Without fail, it seems that the key to building wealth is owning a variety of quality assets that grow in value over time and that can be turned into cash. Here are some important asset classes to know:
Cash/Cash equivalents (Short-term investments)
When we say cash, we are not usually talking about the dollar bills in your wallet. Cash is the money that you hold in easily accessible short-term savings instruments. Examples include savings accounts, money market funds, CDs, etc. This asset class is usually the go to for immediate needs.
A bond is an investment that represents a debt. When you invest in a bond, you are essentially loaning a corporation or a government money and in return, they promise to pay you interest. At some point, there is a promise to pay you back your full investment. There are various types of bond structures with different rates and terms.
A stock represents ownership. When you purchase stock, you become a shareholder of the issuing company and in return your investment participates in the value of the company. Over time, your objective as a shareholder is to see your value grow and/or receive income through dividends. Stocks are divided up into several different classes based on the size of their value, the country that they are in, the industry that they are in, or the characteristics of their business growth.
Commodities are typically called alternative asset classes. These include oil and gas investments, raw materials, natural resources, metals, etc.
There are several ways to invest in real estate. Real estate may refer to commercial or residential properties. Investing in real estate may involve direct ownership of a property or shares of a property/properties.
Often, this is an overlooked asset class when discussing an investment portfolio. Owning a business is definitely an investment. Whether participating or non-participating in the business, private ownership of a company often requires more of your attention and commitment, but also can have some of the greatest reward.
The list goes on…
There are many more types of investments and we have seen popular growth lately in digital asset classes lately like cryptocurrency and non-fungible tokens (NFTs). However, the asset classes above are the fundamental building blocks of a diversified portfolio.
Invest with Purpose
Maintaining a diversified investment portfolio is part of being deliberate in the investment process. You should always know why you own what you own and continually assess if the asset meets your investment objectives.
Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.