If you’ve ever dipped your toe into the investment world, one of the first concepts you probably learned was diversification—and with good reason, as it’s one of the golden rules of investing. But why? It all comes down to managing risk.
Here’s a real-life cautionary tale that shows you what happens when you don’t diversify your investments. Let’s say after a couple of decades in the workforce, you finally get an opportunity to work at “America’s Most Innovative Company.” At least, that’s what Fortune magazine has been calling it for 6 years. You’re thrilled at the opportunity and pour your heart and soul into your work. As an employee benefit, they offer a retirement plan and you even have the opportunity to invest that money into your own company’s stock. It would be crazy not to invest in the country’s most innovative company! By age 50, your accounts have surpassed a million dollars and you’re starting to plan an early retirement.
Does that sound like a dream to you? It did to many. Unfortunately, though, it turned out to be a nightmare. You see, that company was so innovative that they got overly creative with their accounting as well. Its name was Enron. You’ve surely heard of Enron’s accounting scandal and how many of their employees lost their entire life savings and their jobs at the same time.
Putting all your eggs in one basket? That is the opposite of diversification.
The sad story of Enron’s employees was a wake-up call for many, and America learned well the dangers of investing everything in one single company. When most people think of diversification, they think of investing in a broad array of stocks, in companies of different sizes and different industries.
That is one kind of diversification, and it does a good job of reducing the unsystematic risk of a stock portfolio. Unsystematic risk is company-specific risk. If you invest in a bunch of different companies, it won’t affect you as much when one of them fails.
It does nothing for systematic risk, though. That’s the risk associated with the stock market as a whole. The stock market moves in cycles, so it goes up and down with regularity. If you have everything invested in the stock market, then when it goes down, you’re going down with it.
For most people, it’s good to invest in stocks. However, it’s even better to invest in more than just stocks. If you invest across various asset classes, then when you lose money in the stock market, you may still be making money elsewhere. For that to happen, you have to invest in uncorrelated asset classes. Uncorrelated simply means that they aren’t so interrelated that they move in the same direction.
Bonds are another popular investment option because they have a very low correlation with stocks. Sometimes they move in the same direction, sometimes they don’t. Their performance is not tied to each other and therefore they provide better diversification. They also are less volatile, so they don’t take investors on as much of an emotional roller coaster ride.
Other fixed-interest investments with a low correlation to the stock market are T-bills and certificates of deposit (CDs). These are often used to anchor a portfolio and provide protection of capital.
Real estate is another good investment with a low correlation to the stock market. Real estate is popular because it is a very tangible asset and many people already participate in the real estate market through owning their own homes.
It’s common for investors to shy away from real estate, though, because it costs a lot of money to purchase an entire home or they don’t want the work and risk of being landlords. Those can both be major barriers to entry into the real estate market.
If investing in real estate has crossed your mind, here’s the good news: you don’t have to purchase property directly to invest in real estate. You can invest in a real estate investment trust (REIT). REITs sell like stocks on exchanges and invest directly in properties or mortgages. Through a REIT, you can reap the high yields of investing in real estate but have higher liquidity than you would if you owned property directly.
As you can see, it isn’t enough to simply have a diversified stock portfolio. You need to diversify your portfolio beyond just stocks if you want to reduce volatility and improve overall performance. Lucky for you, there are a number of uncorrelated asset classes available to you.
How is your current portfolio? Is it well diversified? You may not be at risk of experiencing what the Enron employees did, but could you still have more risk than necessary? The best way to find out and build an investment portfolio that will limit your risk exposure and allow you to achieve your goals is to work with an experienced financial advisor. For a complimentary consultation, call our office today at 866.888.6563.
Cypress Wealth Services is an independent RIA firm providing financial planning and investment management to high net worth individuals, families, business owners, and institutions. Cypress Wealth Services comprises professionals with diverse backgrounds and extensive experience and qualifications. Cypress Wealth Services is uniquely qualified to serve a broad range of client needs, and their experience and expertise act as a foundation for their client service process. The firm uses The Second Growth, which focuses on efficiently protecting, growing, and transferring to their loved ones the wealth and legacy a person has already built. With offices in Palm Desert, CA, Tustin, CA, and Anchorage, AK, the firm serves clients across the country in Wealth Management Services, Fiduciary Services, 401(k) Design and Management, Investment Reporting Services, Financial and Retirement Planning, and more. For more information, visit www.CypressWS.com or call 760.834.7250.
