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Diversify Investments to Reduce Risk
By John M. Gannon
SUMMER 2009 Putting your money in more than one investment reduces your risk of losing everything should one investment perform poorly. The recent economic downturn has caused many investors to wonder what they can do to keep investment losses in check and lay the groundwork for future gains. A tried-and-true technique to employ is diversification. The basic strategy behind diversification is to spread your risk by spreading your investments. While the old saying "don't put all your eggs in one basket" describes diversification well, you can see the strategy at work with a street vendor who sells both umbrellas and sunglasses in a city where it sometimes rains. On rainy days, umbrellas are likely to be popular—on sunny days, it's a good bet that sunglasses will be the stronger seller. By selling both products, the vendor minimizes his risk that the weather on any given day will devastate his profits. The same lesson applies to investing—by putting your investment dollars in more than one place (and not merely in a single stock or bond), you reduce your risk of losing everything if a single investment performs poorly.
Diversification "Two Step"
There are various degrees of diversification. It is widely recommended that investors employ a two-step process. First, diversify across different asset classes. This means spreading your investments among multiple asset classes —including stocks, bonds, and cash—instead of investing in a single asset class, such as stocks. If you are investing in the Thrift Savings Plan (TSP), for instance, consider directing money not only to stocks (such as the C, S, or I Funds), but also to government securities (G Fund) and corporate bonds (F Fund).
Step two is to diversify within a given investment class. For example, within the stock category, you might choose to invest not only in large companies (or mutual funds that invest in large companies), but also in mid-sized or small companies. Why? Because there are times when the performance of small company stock outpaces the performance of larger, more stable companies, and there are times when small company stock falters. Diversifying among these different categories allows you to capture a broader spectrum of opportunity, while at the same time limiting your downside risk that one category within an asset class will falter.
You can further diversify within an asset class by making sure the investments in your portfolio represent different sectors of the economy, such as technology companies, manufacturing companies, pharmaceutical companies, and utility companies. In addition, you might also want to invest in companies located in different geographic locations. If you're buying bonds, you might choose bonds or bond funds from different issuers—the federal government, state and local governments, and corporations. You may also select bonds or bond funds that mature at different times, or have different credit ratings and other characteristics.
Putting this intra-asset class diversification strategy into practice with the Thrift Savings Plan, you might consider allocating funds to more than one stock fund—perhaps even all three (C,S and I Funds). You can also consider allocations to both the Government Securities Investment Fund (G Fund), which invests in US Treasuries, and the Fixed Income Index Investment Fund (F Fund), which invests in highly rated corporate bonds.
How Much Diversification?
In contrast to a limited number of asset classes, the universe of individual investments is huge. Which raises the question: How many different investments should you own to diversify your portfolio broadly enough to manage investment risk? Unfortunately, there is no simple or single answer that is right for everyone. Whether your stock portfolio includes six securities, 20 securities, or more is a decision you have to make in consultation with your investment professional or based on your own research and judgment.
In general, however, the decision will depend on how closely the investments track one another's returns—a concept called correlation. For example, if Stock A always goes up and down the same amount as Stock B, they are said to be perfectly correlated. If Stock A always goes up the same amount that Stock B goes down, they are said to be negatively correlated. In the real world, securities often are positively correlated with one another to varying degrees. The less positively correlated your investments are with one another, the better diversified you are.
With any investment strategy, it's important that you not only choose an asset allocation and diversify your holdings when you establish your portfolio, but also stay actively attuned to the results of your choices. A critical step in managing investment risk is keeping track of whether or not your investments, both individually and as a group, are meeting reasonable expectations. Be prepared to make adjustments when the situation calls for it.
MUTUAL FUNDS: Instant Diversification?
One of the benefits of investing in mutual funds is diversification. But keep in mind that not all mutual funds provide instant diversification, especially if the fund focuses on a single industry sector. Some funds focus on only a very narrow slice of the market, such as bio-tech companies, companies located in China, or bonds that carry non-investment grade ratings. You may need to invest in more than one mutual fund to get the diversification—both within and across an asset class—that you seek. If you invest in multiple funds, it's also a good idea to review a fund's primary investments, to determine the extent to which they overlap with the holdings of other funds you own.
One strategy investors increasingly use to diversify and to avoid over- or under-concentration in a given asset class is to invest in a "lifecycle fund." A lifecyle fund is a diversified mutual fund that automatically shifts towards a more conservative mix of investments as it approaches a particular year in the future, known as its "target date," such as 2015 or 2040. The TSP's "L" Funds are examples of lifecycle funds. Depending on the target date, the fund allocates among all of the TSP investment funds and adjusts quarterly to more conservative investments as the fund's time horizon shortens.
John M. Gannon is Senior Vice President of FINRA, the world's leading private-sector provider of financial regulatory services. Visit www.saveandinvest.org, a comprehensive website to help servicemembers manage their money with confidence.