The Importance of Diversification

The importance of diversificationIn times of economic uncertainty, I like to focus the conversation regarding investing to risk tolerance and diversification. These are tumultuous times. We have the issues with the pandemic, politics, and social divisions across the globe. People are genuinely concerned. During these troubled times it is important to focus on the guidance God has delivered to us regarding our stewardship. King Solomon gave wonderful advice concerning diversification.

Ecclesiastes 11:2

Invest is seven ventures, yes, in eight; you do not know what disaster may come upon the land.

Why diversify?

The goal of diversification is not necessarily to boost performance—it won’t guarantee gains or guarantee against losses. Diversification does have the potential to improve returns for the level of risk you choose to target.

To build a diversified portfolio, you should look for investments—stocks, bonds, cash, or others—whose returns haven’t historically moved in the same direction and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much.

Another important aspect of building a well-diversified portfolio is trying to stay diversified within each type of investment.

Within your individual stock holdings, beware of overconcentration in a single investment. For example, you may not want one stock to make up more than 5% of your stock portfolio. It’s smart to diversify across stocks by market capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps, sectors, and regions have prospered at the same time, or to the same degree, so you may be able to reduce portfolio risk by spreading your assets across different parts of the stock market. You may want to consider a mix of styles too, such as growth and value.

When it comes to your bond investments, consider varying maturities, credit qualities, and durations, which measure sensitivity to interest-rate changes.

 

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