| November 18, 2008 |
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Are Your Assets Really Diversified?
by John Litscher, CFP
Photo by Eric Tadsen
John Litscher is Forté Madison's resource for financial advice.
You've heard the old investment adage, "Don't put all your eggs in one basket." It's good advice. A diversified portfolio should be at the core of any well-planned investment strategy. It’s a worthy goal at any age, but it's especially desirable as your net worth grows over the years.
The purpose of diversification is to reduce your portfolio risk and volatility. It's primarily a defensive investment strategy. Depending on your investment goals and tolerance for risk, your strategy may emphasize one type of investment over another. But overall, your portfolio should be diversified because no single type of investment performs best under all economic conditions. A diversified portfolio is capable of weathering varying economic cycles and improving the trade-off between risk of loss and potential return. Diversification cannot entirely eliminate the risk of investment losses or guarantee a profitable investment return. Diversification lowers the risk of as portfolio.
Forms of Diversification.
An investment portfolio consisting of twenty different construction industry stocks is not diversified. Diversification means dividing your funds among different asset classes, such as stocks, bonds, real estate, savings accounts and tangible assets. For instance, suppose your portfolio consisted entirely of bonds. Your money would be at significant risk if interest rates rose since bond prices generally fall when rates go up.
It's also important to diversify by owning several stocks in different industries. Suppose you held just 1,000 shares of a major company’s stock from December 31, 2004, through December 30, 2008, and you suffered a loss of $40 per share when the stock fell from 100 to 60. A diversified portfolio consisting of many different stocks in various sectors may have cushioned the blow of the loss.
Prudent investors managing their own portfolios might diversify their holdings by selecting some stocks for their rising earnings, or accelerating “growth” potential while buying other stocks because they offer “value” by temporarily being out of favor. In addition, investors may buy individual securities for other reasons, such as dividends or a special situation in the marketplace.
Diversification also means not tying up all your funds in long-term investments. You'll need to keep a certain amount easily accessible—that is, in money-market accounts, savings accounts or short-term certificates of deposit (CDs)—for on-going expenses, emergency needs and short-term goals, such as saving to buy a car or pay taxes. And through dollar-cost averaging, a process of buying stocks and bonds periodically instead of all at once, you spread the risk over both good and bad markets. Using dollar cost averaging involves continuous investment in securities regardless of fluctuating price levels of securities. Therefore, investors should consider their financial ability to continue purchasing through periods of fluctuating price levels. Dollar cost averaging does not ensure a profit and does not protect against a loss in declining markets. Diversification is also important because CDs are FDIC-insured and typically offer a fixed rate of return while investments such as stocks and bonds are not FDIC-insured and their value will fluctuate with current market conditions.
Ultimately, the most important thing to do before you decide to invest is to think about what you are investing for. Your investment dollars should be working for you, not the other way around. You should have an idea of how long you can hold the investment, what you will use the money for, and whether or not you will accept fluctuation in the value of the account. It’s your future, now go plan for it.
John Litscher, CFP® is a registered representative and investment advisor representative with Lincoln Financial Advisors Corp., a broker/dealer and registered investment advisor, member SIPC, 406 Science Drive, Suite 100, Madison, WI. 53711. This information is prepared for general circulation and information and does not have regard to any specific investment objectives. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. The content of this material was provided to you by Lincoln Financial Advisors Corp. for its representatives and their clients.
CRN200810-2022141
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