You don't need to be an investing genius to understand the importance of a diversified portfolio. If you put all your money in a single stock and that company goes out of business, you lose everything. Spreading your money around helps reduce this risk. But if you're just putting your money in stocks, you're probably experiencing a false sense of security.
Is your portfolio less diverse than you think?
Stocks have incredible earning potential, but they're highly volatile. The S&P 500 — a market index that tracks 500 of the largest companies in the U.S. — has seen annual returns of over 30% and losses of nearly 40% in the last 30 years. If you'd invested all your money in an index fund tracking the S&P 500 over that time, you'd see huge gains some years and devastating losses in others.
Over the long term, stock values tend to increase, but these short-term swings are problematic for those who plan to sell their stocks soon, like retirees. When you need your money, you have to sell, regardless of what your stocks are worth — even if it's the year your investments take a huge dive.
The simplest way to avoid these massive losses is to gradually move your money out of stocks and into safer assets, like bonds, as you approach the time when you plan to start making withdrawals. A general rule of thumb for determining how much of your retirement savings should be in stocks is 110 minus your age. So if you're 50, you should have 60% of your money invested in stocks and 40% in bonds.
Bonds don't generate the same returns as stocks, but they can still help you grow your savings more quickly than you could with a savings account. Plus, bonds are less volatile so they can help you protect what you already have.
How diversified are your stocks?
In addition to limiting your exposure to stocks, you also have to limit your exposure to certain sectors to ensure that industry shifts don't devastate your portfolio. For example, if you had pretty much all your money invested in airline stocks, restaurants, hotels, and other tourism-related businesses, 2020 would've hit you hard. The nationwide lockdowns crippled many of these companies, driving some out of business altogether.
But if you'd had some of your money in tech stocks, which have done extremely well during the pandemic, you would've weathered the storm a lot better. The tech stocks' gains would've balanced out some of your other stocks' losses.
That's not to say pouring all your money into tech is a great idea either. While it seems like an industry that's almost always thriving, you never know when some type of new regulation or industry shift could send these businesses into a tailspin.
It's better to invest in a variety of sectors so no one weighs too heavily on your portfolio. Index funds are a great way for beginners to do this. S&P 500 index funds, as discussed above, give you ownership in 500 of the largest U.S. companies in many different industries. You could also choose your own stocks, though this requires a bit more investing expertise. It may also require more money, unless you're purchasing fractional shares.
Need to make some adjustments?
If any of this information was new to you, you should probably take a look at your portfolio and decide if you need to make any changes. If you do, you have two choices. You can sell some of your investments and use that money to invest in other things. Or you can invest more of your savings in other things until you've reached your desired asset allocation. It depends on how much cash you have to spare.
Once that's done, see if you can set up automatic contributions so you don't have to worry about making them manually. Then, check in with yourself once or twice per year to decide if you need to make any further adjustments. You'll need to move more of your money into bonds over time, as discussed above, and you may need to rebalance your portfolio periodically if one or two well-performing stocks become overweighted.
It takes a bit of work, but it's one of the best things you can do to minimize your risk of loss, so it's definitely worth the effort.
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