What is Strategic Diversification?
Diversification 101 – The Basics
When deciding how you want to structure your investments, as part of your overall investment management plan, you’ll no doubt come across the phrase “diversification.” While part of a bigger strategic asset allocation plan, strategic diversification is an important tool for managing risk exposure. By allocating your investment into different types of investment classes, investors are not left exposed to any one investment or risk.
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In the case of an underperforming investment, this could decrease your risk for loss. Conversely, this can also limit your returns on a higher-performing investment, but such is the nature of investing. Without the ability to predict the future of the markets, it’s all about calculating risk and reward and making changes when appropriate.
Simply put, the basic principle of strategic diversification is to not put all of your eggs into one basket. And while strategic diversification can’t guarantee that you’ll avoid losses entirely, it can help buffer your portfolio from the ups and downs of the market, also known as market volatility.
Understand the Learning Curve
As when you learn any new skill, strategic diversification investing has its own learning curve. It may take some time before you hit your stride and feel confident about how you want to spread out your investments. It’s important to be patient and understand that abrupt (and sometimes emotional) decisions about your portfolio in reaction to activity in the markets can be detrimental.
This is especially true when your strategic diversification is part of a bigger plan, such as strategic asset allocation. These plans are often built for the long-term, meaning that they anticipate shifts in the market and are designed to weather those storms without drastic changes to your investment strategy.
At Financial Freedom Fee-Only Wealth Management, once an appropriate asset allocation has been developed for a client, the second key step is developing a well-diversified equity and fixed income portfolio.
To diversify your portfolio and further reduce risk, Financial Freedom will allocate your assets between a number of asset classes, using individual stocks, bonds, and no-load/low load mutual funds.
Types of Assets In A Strategically Diversified Portfolio
Domestic Stocks are stocks of American companies. Overall, stocks are going to represent the most opportunity for growth, but also represent the highest risk. Because of the volatility with the stock market, the values of stocks change rapidly and should be monitored closely.
Bonds are one of the ways you can shield your portfolio against volatility. Because they provide regular interest income and are considered generally “safer” investments than stocks. However, most bonds don’t offer a high return and as such are generally used for those looking for safety over growth in their portfolio, such as those closer to retirement and more adverse to risk.
Cash and Short-Term Cash-Equivalents (CCE) include money markets and CDs (certificates of deposit). These types of conservative investments are favored by those who prefer stability and liquidity – in the case of money market accounts. However, CDs do sacrifice that liquidity unless you want to pay a penalty to liquidate, which in some cases would nullify your dividends altogether.
Real-Estate funds include land, buildings, livestock, and agriculture. These funds are generally considered “stable” and are known to add stability to a portfolio and protect against the volatility of other high-risk investments such as stocks. However, the real estate market has been known to have its own ups and downs, so as with every investment it should be considered for its risk/reward potential.
International Stocks are issued by non-U.S. companies. As such, they tend to perform differently than domestic stocks. This is because something happening within the U.S. economy may not affect what’s happening overseas, and vice versa. This type of investment—while still volatile since after all, it’s still a stock—can protect against any economic crisis in the U.S. while still providing a high-yield potential from growth in foreign markets.
Exchange-Traded Funds (ETFs) are investment funds that are traded on stock exchanges. They typically track an index, commodity, bonds or securities. Unlike mutual funds, however, these funds experience price changes throughout the day as they are traded. Think of them as a stock/mutual fund hybrid with less risk than stock but more risk/earning potential than a mutual fund.
Commodities are usually for the more advanced investor. That’s because this class of investments include the basic goods necessary for production of the things the world needs and uses most and hence can be very unstable. Examples include grain, oil, orange juice, and beef to name a few. One way to mirror the investment of commodities in a safer environment is to purchase funds that utilize products from the commodities industry to help diversify your portfolio.
Financial Freedom Wealth Management’s process:
Once an appropriate asset allocation has been developed, the second key step will be developing a well-diversified equity and fixed income portfolio. To diversify your portfolio and further reduce risk, Financial Freedom will allocate your assets between a number of asset classes, using individual stocks, bonds and no load/low load mutual funds. On the equity side, we focus on six primary asset classes: large cap, small cap, mid cap, international, energy/natural resources, and real estate.
Financial Freedom is a member of the Fidelity Investments Institutional Wealth Services group. Fidelity Investments, located in Boston, MA, is one of the largest financial services companies in the world. All of our client’s assets are custodied at Fidelity, where each client has their own individual account.
Know Your Time Horizon
For most investors, there is a finite amount of time before you will need to access the funds you’re using to invest. This timeline is usually based on when you plan to retire. When initially structuring your strategic asset allocation and diversifying your portfolio, you and your financial advisor should take many things into consideration, including your age, risk tolerance, and goals for your overall portfolio. From there, you can make a plan on where you can take some risks and where you should play it safe based on the types of investments available to you and your comfort level.
At Financial Freedom, we understand that your objectives may change, which is why we’re always ready to adapt our strategy. Whether working toward growth or protecting your principal, the skilled financial planners at Financial Freedom structure plans that evolve with your needs.
Find a Financial Advisor Who Understands Your Diversification Needs
If you are looking for investment management and a financial planner who has an understanding of strategic diversification as part of an overall strategic asset allocation plan, you’re in the right place. Contact Financial Freedom Fee-Only Wealth Management today!
Filed Under: Comprehensive Financial Planning