An important way to reduce the risk of investing is to diversify your investments. Diversification is akin to “not putting all your eggs in one basket.” For example, if your portfolio only consisted of stocks of technology companies, it would likely face a substantial loss in value if a major event adversely affected the technology industry.
There are different ways to diversify such a portfolio:
*You could invest in the stocks of companies belonging to other industry groups.
*You can allocate your portfolio among different categories of stocks, such as growth, value, or income stocks.
*You may include bonds and cash investments in your asset-allocation decisions (potential bond categories include government, agency, municipal, and corporate bonds).
*You might also diversify by investing in foreign stocks and bonds.
Diversification requires you to invest in securities whose investment returns do not move together. In other words, their investment returns have a low correlation. The correlation coefficient is used to measure the degree to which returns of two securities are related. For example, two stocks whose returns move in lockstep have a coefficient of +1.0. Two stocks whose returns move in exactly the opposite direction have a correlation of -1.0. To effectively diversify, you should aim to find investments that have a low or negative correlation.
A simple way to achieve diversification is with mutual funds and ETFs, or exchange traded funds. Mutual funds hold hundreds of securities in their portfolios. This provides a diversification advantage. You do face yearly management expenses with mutual funds, which typically run around 1.5% of your investment each year.
On the other hand, ETFs are instruments that are traded like stocks but they hold securities, such as stocks or bonds, like a mutual fund (typically to replicate an index, such as the S&P 500 or the Dow Jones Industrial Average), but annual costs are typically much lower. Though not as varied or usually as flexible as mutual funds, these investment vehicles can be an easy method to achieve diversification in investing.
To learn more about mutual funds and ETFs, call one one of Zions Direct’s investment advisers at 800-524-8875 and they will be happy to assist you.
*Artwork from roctopus under Creative Commons license at Flickr.com.
