Like the FIX engine and other basic aspects of trading today, the concept of investment diversification is something everyone knows about. When you spread your investments across different categories, you’ll reduce your risk of loss. This is why because when one holding moves lower, chances are another is moving higher. A perfect example of this is seen in the typical upward movement of bonds when stocks move low. However, despite the need for diversification being common knowledge, many investors still don’t do as well as they should.
Multiple funds don’t automatically mean diversification
When you own multiple mutual funds, you may think that the holdings are diversified. However, that is often not the case. When you look at the types of stocks held across those funds, you may just find that they are all part of the same asset class, such as big US companies. You have several different eggs, but unfortunately, they’re all still in the same basket.
What to do
There are many steps you can take to diversify your holdings. Investing globally will help cut down your risk, but many people don’t do that despite technology such as the FIX engine making it possible. Although US companies account for about half of the world’s total market capitalization, the average US-based investor still puts 70 percent of their portfolio into US holdings.
Investing across various asset classes is another must for a truly diverse portfolio. To do this, you’ll first need to decide how much should go into the largest and most broad asset classes, namely bonds and stocks. A more conservative investor may have 30 or 40 percent of their money in stocks, for example, but a more aggressive one may be closer to 60 or 80 percent. The balance left over would go the bond side.
Once you’ve decided how to handle stocks and bonds, you can allocate geographically to diversify your holdings. You could, for example, place 50 percent of your stock allocation into US stocks – which matches the US capitalization mentioned above – and then put another 25 percent into developed countries overseas in Australia, Asia, or Europe. The remaining stock can go to emerging markets, such as those in India or China. You can then use a similar approach with the bond side of your portfolio but with a little more exposure to the US, as it makes up around 60 percent of the global bond market.
Finally, you can diversify within those geographical asset classes. Your investment dollars can be spread across companies of various sizes, as you will want to have exposure to small, medium and large companies in all three markets at home, abroad and in the emerging markets.
When your portfolio is truly diversified, you will reduce your risk and maximize returns by lessening the chance that a significant event in a market will have a devastating impact on your entire portfolio. If you are not sure how diversified your holdings are, take a closer look and make the appropriate changes.