You're almost certainly familiar with diversification, but it is also one of the most misunderstood investment concepts.
Diversification is one of the most commonly discussed topics among all types of investors from those just starting out to the largest money managers on Wall Street. The reason: 'Diversification is, without question, one of the keys to your success as an investor,' says Steve Fortin, a director of planning with Lincoln Financial Advisors in Cincinnati, Ohio. 'But you must employ it correctly and affluent investors have more options than anyone.
As an investor, it's crucial to ask yourself two important questions about your portfolio: Am I truly diversified? And am I taking advantage of all the strategies at my disposal to capture the full range of diversification benefits? Discussing the following strategies with your financial planner can help you answer "yes" to these questions.
The basic idea behind diversification is simple: Don't put all your eggs in one basket. That said, simply owning a large number of stocks or other investment doesn't automatically make you diversified. The key, says Fortin, is to spread your capital across a wide variety of asset classes and asset styles that have fundamentally different risk and return characteristics.
Such investments typically behave differently from each other during a market cycle bonds often perform well during periods of stock market weakness, for example, while some international shares might rally when the U.S. market falls. By combining these and other types of asset classes, you can enhance your portfolio's return potential, while simultaneously lowering its overall level of risk.
These advantages can be especially important for investors looking to preserve what they've earned. For example, consider an executive whose wealth is concentrated in his or her company's stock. "The same stock that makes an investor wealthy can also damage that wealth if it runs into trouble, as we've seen in recent years with many companies," says Fortin. "If one of your goals is to preserve your capital, diversification is an absolute must."
Diversification is a useful technique that can reduce overall portfolio risk and volatility. Diversification neither ensures against a profit nor protects against a loss. Each investment type has different investment and risk characteristics. Bonds have fixed principal value and yield if held to maturity. Bonds have market risk, interest rate risk and credit risk. Stocks can have fluctuating principal and returns based on changing market conditions. The prices of small company stocks generally are more volatile than those of large company stocks. International investing involves special risks not found in domestic investing, including political and social differences and currency fluctuations due to economic decisions.
Most investors diversify using a combination of stocks, bonds and cash. While those asset classes should form the basis of your portfolio, wealth affords you a range of alternatives that can further enhance your portfolio's diversification. For example:
- Hedge funds.
Hedge funds "overall goal is to generate a positive absolute return in any type of market. Although the strategies these funds use to achieve that goal are seemingly endless, one of the most common is known as market neutral, in which hedge fund managers buy stocks they like while shorting others" allowing the funds to potentially profit from both rising and falling stock prices. Many investors gain access to hedge funds through so-called "funds of funds," which offer exposure to several hedge funds and investment styles through a single offering.
Hedge funds have various risks, including the fact that some hedge funds often engage in leverage and other speculative investment practices that may increase the risk of investment loss; can be illiquid; are not required to provide periodic pricing or valuation information to investors; may involve complex tax structures and delays in distributing important tax information; are not subject to the same regulatory requirements as mutual funds; often charge high fees; and in many cases the underlying investments are not transparent and are known only to the investment manager. Investors must meet accredited investor suitability standards before investing.
- Managed futures.
Futures are contracts involving the purchase and sale of commodities or financial instruments, such as coffee, gold, oil or currencies. Managed futures are not highly correlated to the returns of stocks and bonds'that is, when stocks and bonds move in one direction, managed futures often move in another.
The result: smoother overall returns for your portfolio. Like hedge funds, managed futures funds can employ strategies to potentially make money in both rising and falling market environments. Managed futures funds have various risks, including leverage and other speculative investment practices that may increase the risk of investment loss; can be illiquid; often charge high fees; and in many cases the underlying investments are not transparent and are known only to the investment manager. Investors must meet sophisticated investor suitability standards before investing.
- Non-traded real estate.
Using a limited partnership or REIT structure, you can essentially become a landlord of commercial real estate properties (such as warehouses, office buildings and retail space). Like the commodities market, real estate has a low correlation to other asset classes. And, because these investments aren't traded on the open market, they offer two other distinct advantages: attractive yields and less volatility than publicly traded REITs. Non-traded real estate has risks, including lack of real estate liquidity and property devaluation based on adverse economic and real estate market conditions.
- Oil and gas funds.
Also known as drilling funds, these partnerships offer regular cash flow payments, as well as significant tax advantages (up to 90% of your investment can be written off against your income in the first year). And you guessed it, oil and gas partnerships low correlation to other asset classes make them excellent sources of portfolio diversification. Oil and gas partnerships have risks associated with oil and natural gas drilling and the tax risks associated with an investment in a partnership. Oil and gas partnerships are not suitable for investors in low marginal tax rates or who cannot assume the total loss of an investment in the partnership and are for accredited investors only.
Fortin points out that while large institutions such as pension funds and endowments regularly invest 50% or more of their assets in these and other types of alternative investments, individual investors can reduce risk and boost potential return by allocating as little as 5% to 10% of their portfolios to these options.
Of course, each of these alternative investments also carries its own unique risks that must be weighed before jumping in. Best advice: Discuss issues such as an investment's liquidity, costs and taxes with your financial planner to determine how you might achieve the type of optimal diversification that will help you achieve your short- and long-term goals.
Talk to Your Planner About:
Alternate investments such as hedge funds, managed futures, non-traded real estate and oil and gas funds may be subject to special risks, such as illiquidity. An investor should carefully consider the investment objectives, risks, charges and expenses of an investment before investing.
- Your portfolio's current level of diversification and how it might be enhanced.
- Specific investments that you can use for diversification.
- The pros and cons of each investment option, and how it fits into your overall goals.