What is Diversification: An Example

Diversification

You’ve probably heard, “The best thing you can do with your finances is to put your money to work.” You’ve probably also heard, “The best way to make your money work for you is to invest.”

Both adages are true, but where do you start? How do you invest wisely to maximize the odds that your money grows over time? The truth is investing your money for the long haul is not so much about winning as it is about avoiding losing.

The first thing to understand is you need to treat investing like a time-lapse video, not a snapshot. When you zoom out and look at the several sectors of the market, you will see good times and bad times for all of them. However, in the long run, the general trend is always up. Of course, you won’t be investing for 100 years, so you need to stay covered in case a sector you’re invested in experiences a severe downturn. You can do this by diversifying your investment portfolio.

How Do You Diversify?

Diversification is the practice of investing in many classes of assets. These include equities (stocks), bonds, ETFs, commodities, real estate, and emerging market stocks. Then you can diversify within these classes. For example, a diverse portfolio has stock in both big and small companies which compete in various industries. You also want to make sure some of your stocks provide dividends so you have a continuous flow of income to reinvest. Over time, this will compound your earnings.

Here is a breakdown example of a diversified portfolio:

  • High Yield Dividend stocks: 20%
  • Emerging Market Stocks: 5%
  • Tech stocks: 10%
  • Bank stocks: 10%
  • Industrial stocks: 10%
  • Bonds: 20%
  • Commodities: 15%
  • Real Estate: 5%
  • Money Market: 5%

This is only an example, not meant to be an actual blueprint. It is just to illustrate why it is so important to have a diversified portfolio as you work towards your long-term financial goals. A portfolio like this decreases your risk because you aren’t fully exposed to each sector. With the exceptions of deep recessions, stocks, bonds, and commodities will generally move inversely. Simply put, when stocks go down, bonds go up.

How Diversifying Limits Risk

So let’s use our imaginary portfolio above and say your initial investment is $10,000. Five years later, here’s how each sector performed:

  • High Yield Dividend stocks +0%
  • Emerging Market Stocks -40%
  • Tech stocks -20%
  • Bank stocks +5%
  • Industrial stocks -10%
  • Bonds +5%
  • Commodities +15%
  • Real Estate +5%
  • Money Market +5%

In this scenario, you’re up $25 even though tech stocks and emerging market stocks posted a $400 loss. Now you still have a well-positioned portfolio should your hunches about tech companies and emerging market stocks come true in 20 years. In that case, you bought yourself time to stay in the market longer and benefit from the overall trend, which is always upwards.

Diversification

This brings up another important aspect of maintaining a balanced portfolio over the years: rebalancing. Using the 5-year example above, your initial diversified portfolio percentages are no longer consistent with a balanced and diversified portfolio. This is because your exposure to certain sectors and asset classes has changed. You need to move money from one asset that is doing well, to one which isn’t so your proportions remain balanced. Doing this yourself is a pain.

Hire a Robo-advisor, set it, & forget it!

A simple way to accomplish a diverse and well-maintained portfolio is the use of a robo-advisor. This is a computer system which uses algorithms, data from previous market performance, artificial intelligence, and your specific financial goals to invest your money for you. A robo-advisor will regularly rebalance your holdings, reinvest your dividends, and more. In 2020, robo-advisors managed nearly $1 trillion in assets and experts expect that number to triple in the next few years, showing increased trust and credibility in this investment channel.

So if you want to play the market and want to do it right, trusting a robo-advisor might be the way to go. SmartWealth by NBK Capital will help you get started, advise the best way to diversify your investments based on your preferred level of risk, and will mitigate your risk along the way.

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