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Diversification is important to the long-term stability of any portfolio, but true diversification isnâ€™t uni-dimensional.
If you are a regular reader of Dentist’s Money Digest, you probably know enough about diversification to be dangerous. It might be, though, that you know just enough to be dangerous to your own portfolio.
Diversification can be defined as managing risk by using a wide variety of investments within a portfolio, thereby minimizing the risk of a shortfall in any given investment on your overall investment portfolio. It isn’t done to grow your investment, and it won’t guarantee against losses. But it will provide a layer of safety to your portfolio.
Where investors can get themselves into trouble is misunderstanding what is meant by “a wide variety of investments.” Put simply, many think they’re diversified simply by having different kinds of stocks or bonds, such as a growth stock, a blue-chip stock, and a “sin” stock, such as tobacco. That is one form of diversification, but it may not be enough for most portfolios.
Other kinds of diversification include:
• By type of instrument: for example, an equity investment or a debt investment
• By industry: healthcare, technology, durable goods, and real estate, among many others
• By companies within an industry: If, a decade ago, you had holdings in both Blockbuster and then-emerging Netflix, half of that investment has made it through pretty well!
• For bonds, by length of maturity and possibly by geography (Municipal bonds offer geographic diversification, but corporate bonds do not.)
A truly diverse portfolio doesn’t have to have all these types of diversification, but it should include a few of them. Why? Because some investments, over time, have shown that they typically move opposite of each other, no matter the direction of the economic cycle. So if one portion of your investments is susceptible to a distribution phase, another might perform better during that phase. With an increase in short-term interest rates now official, a diversified portfolio means that if some of your investments take a small hit, others may fare better.
For many, the dream scenario is to establish a practice partnership and sell the practice as you ride off into the retirement sunset, or to get in on the ground floor of a Google, an Apple, or a Mercedes Benz, ride that stock through splits and market cycles, and sell a big chunk of it as you sail off to your favorite fishing destination. If you can pull off one of those scenarios, more power to you! Diversification will not help you much in that scenario, and it could potentially limit the growth of your investment by putting some of those investment dollars into lower-performing vehicles.
But that scenario isn’t realistic for many. Diversification also allows you to be more aggressive with some investments, knowing that if the market takes a tumble, or if the Silicon Valley-based growth stock you’ve latched onto tumbles into the Pacific Ocean during an earthquake, your portfolio won’t completely crumble along with it.
One last word on diversification: like many aspects of investing, it isn’t a one-time deal. As your financial circumstances and goals change, so should your portfolio mix. Look at your investments at least annually to make sure the risk level you’re at is the one you want.