Yesterday, things got real. The Dow was down 800 points and all the major indexes declined. The 10-year Treasury bond yield fell below the yield of the 2-year Treasury bond which has historically been a predictor of recessions. Let’s be clear, we’re not in a recession yet and Wall Street nerds are hopeful that the strong fundamentals of the economy will ultimately work to continue the economic expansion. But still, none of this volatility feels good.
One way to limit the risk in your investment portfolio is through diversification. Diversification is basically the concept of not putting all of your eggs in one basket. So, if you are invested in ten stocks, the idea is that not all of them will lose money at the same time. In fact, the more diversified your portfolio is, the more the risk is reduced. As with most things, there are levels to this.
You should be thinking about diversification in several ways:
- Diversify by asset class – Choosing an appropriate mix of different asset classes such as stocks, bonds, or REITS.
- Diversify by security – Investing in multiple securities within each asset class.
- Diversifying in assets with correlation – Selecting assets that don’t move together. Correlation is represented by a number from -1 to 1. If investments are positively correlated, they will move in the same direction and be represented by a positive number. If two assets are negatively correlated, they will move in opposite directions and be represented by a negative number. A correlation of zero means that the two assets do not move dependent of one another.
Diversification is not hiring multiple financial advisors to manage your investments. It’s also not having bank accounts with different banks. In fact, these scenarios may possibly cost you more money in fees.
