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Welcome to Select’s newest advice column, Getting Your Money Right. Once a month, financial advisor Kristin O’Keeffe Merrick will be answering your pressing money questions. (You can read her last installment here on how rising interest rates impact your investment portfolio.) Have a question you want to ask? Send us a note at AskSelect@nbcuni.com.
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Dear Kristin, With the recent downturn in the stock market, I am trying to look for ways to protect my portfolio. I know of the adage, “diversify, diversify, diversify” but what does that actually mean? And how do I go about diversifying to protect my investments in volatile markets? Signed, Diversifier from Denver Dear Diversifier, During the financial crisis in 2007-2009, I was a currency trader at a large international bank and saw some really crazy market occurrences that still make my blood curl. During that time, we witnessed an unprecedented plummet in asset prices as we were on the brink of total market collapse. When Lehman Brothers went bankrupt, we hired one of their former currency traders — on his first day, he cried. Yes. A grown man cried to me on his first day of work. Why? Because he had lost his entire life savings. Prior to the crisis, the culture at Lehman Brothers was to accrue company stock and not sell it. As a result, when Lehman collapsed and the stock went to zero, many people, including my new colleague, lost everything. This is a cautionary tale of why we need to diversify our portfolios. The Lehman employees at that time had concentrated their portfolio into one stock, which seriously endangered their financial well-being.
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Why it makes sense to diversify your portfolio
When you think about building an investment portfolio, it helps to imagine a spectrum that ranges from concentrated to diversified. A concentrated approach is analogous to putting all your eggs in one basket, while an extremely diversified portfolio means you own many securities ranging from stocks and bonds to currencies and commodities. In my opinion, neither end of the spectrum is advisable. I think I have made my case as to why you wouldn’t want to have too much concentration in your portfolio, so let’s shift toward what diversification actually means and why it’s important. Diversification is the concept of putting your money into various types of investments that often don’t react the same way and at the same time to market volatility. A diversified portfolio could have different types of securities, such as large cap stocks, small cap stocks, international stocks and stocks from all types of different industries. If your existing portfolio only holds five U.S. based tech stocks, for instance, it’s not considered to be diversified. However, if you hold a U.S. tech stock, as well as stocks from an energy company, a real estate company, a small chip maker from Taiwan and gold, you could argue that your portfolio is diversified. If you want to easily create a diverse portfolio, consider using a robo-advisor, which will use its algorithm to automatically build you a custom portfolio based on your risk tolerance, investing goals and time horizon — plus they’ll automatically rebalance your investments over time. Select ranked Wealthfront and Betterment as some of the best robo-advisors. For those who want a more hands on approach, you could buy an index fund or mutual fund through a broker like Charles Schwab or Vanguard.
Wealthfront Learn More On Wealthfront’s secure site Minimum deposit and balance Minimum deposit and balance requirements may vary depending on the investment vehicle selected. $500 minimum deposit for investment accounts
Fees Fees may vary depending on the investment vehicle selected. Zero account, transfer, trading or commission fees (fund ratios may apply). Wealthfront annual management advisory fee is 0.25% of your account balance
Bonus None
Investment vehicles Robo-advisor: Wealthfront Automated Investing IRA: Wealthfront Traditional, Roth, SEP and Rollover IRAs Other: Wealthfront 529 College Savings
Investment options Stocks, bonds, ETFs and cash. Additional asset classes to your portfolio include real estate, natural resources and dividend stocks
Educational resources Offers free financial planning for college planning, retirement and homebuying Terms apply.
Betterment Learn More On Betterment’s secure site Minimum deposit and balance Minimum deposit and balance requirements may vary depending on the investment vehicle selected. For Betterment Digital Investing, $0 minimum balance; Premium Investing requires a $100,000 minimum balance
Fees Fees may vary depending on the investment vehicle selected. For Betterment Digital Investing, 0.25% of your fund balance as an annual account fee; Premium Investing has a 0.40% annual fee
Bonus Up to one year of free management service with a qualifying deposit within 45 days of signup. Valid only for new individual investment accounts with Betterment LLC
Investment vehicles Robo-advisor: Betterment Digital Investing IRA: Betterment Traditional, Roth and SEP IRAs 401(k): Betterment 401(k) for employers
Investment options Stocks, bonds, ETFs and cash
Educational resources Betterment RetireGuide™ helps users plan for retirement Terms apply.
Vanguard Learn More Minimum deposit and balance Minimum deposit and balance requirements may vary depending on the investment vehicle selected. No minimum to open a Vanguard account, but minimum $1,000 deposit to invest in many retirement funds; robo-advisor Vanguard Digital Advisor® requires minimum $3,000 to enroll
Fees Fees may vary depending on the investment vehicle selected. Zero commission fees for stock and ETF trades; zero transaction fees for over 3,000 mutual funds; $20 annual service fee for IRAs and brokerage accounts unless you opt into paperless statements; robo-advisor Vanguard Digital Advisor® charges up to 0.20% in advisory fees (after 90 days)
Bonus None
Investment vehicles Robo-advisor: Vanguard Digital Advisor® IRA: Vanguard Traditional, Roth, Rollover, Spousal and SEP IRAs Brokerage and trading: Vanguard Trading Other: Vanguard 529 Plan
Investment options Stocks, bonds, mutual funds, CDs, ETFs and options
Educational resources Retirement planning tools Terms apply.
How hedging plays a role in portfolio diversification
Adding different securities to your portfolio to reduce risk is the act of diversification. One way to diversify is by hedging, or “putting on a hedge” — it’s a buzzy Wall Street term but it shouldn’t be a scary word. Hedging your portfolio simply means you are reducing unsystematic risk, which is a company or industry-specific risk that is inherent in each security. For example, an unsystematic risk for a car company would be a product recall. While a recall would be an issue for that specific company, it wouldn’t be for the entire automobile industry or the overall economy. A timely example of hedging would be if you owned energy stocks in your portfolio. Given the overall market environment, most stocks and bonds have corrected lower while energy-related securities have rallied. This is a scenario where you likely have lost money on your stocks and bonds but have made money on your hedge (energy position). The general rule about diversification is that it reduces your unsystematic risk but does not eliminate all of your risk. The sibling to unsystematic risk is systematic risk, which can be attributed to broad market factors such as inflation and higher rates, as we have witnessed over the past few months. While it’s extremely difficult to eliminate systematic risk, it’s possible through some hedging strategies. For example, an investor can use options as a way to hedge. An option is a security that is used to protect your investment from large downside moves. However, to buy an option, you have to pay a premium. You must keep that premium payment top of mind when deciding if the economics make sense to put a hedge on. Remember that a reduction in risk overall could be a good strategy, but it will also reduce your potential profits. Note that options are complicated and not for novice investors. Do not use options if you are new to investing unless you’re working with a financial professional.
Be careful not to over diversify
While diversification is important, it’s crucial that you don’t over diversify. Often I will look at new clients’ portfolios and one of the mistakes they (or their former financial advisors) have made is that it has too many securities. Often, they own more than 10 exchange-traded funds, or ETFs, and/or mutual funds in the same portfolio. Remember that each mutual fund or ETF could own 50 to 500 securities, meaning if you own 10 mutual funds, you could actually own over 5,000 holdings. It’s very hard to make decent returns on your investments when you own that many securities. Think about cooking your favorite dish. If you use too many different spices, it becomes difficult to taste anything and you’ll eventually ruin the meal. This is similar to over diversification. Overall, you want to be somewhere on the diversification spectrum, but not overdo it. If you own too much of one stock, you should put a plan in place to liquidate some of it and put the proceeds into a more diverse portfolio. Note, however, that there are tax consequences when it comes to reducing your position so make sure to work with a financial professional and find out the best way to reduce some of your positions before hitting that sell button. I hope this helps clear up a few things. I know this market has been a doozy but let’s hope for better days ahead. Good luck! Kristin O’Keeffe Merrick is a Financial Advisor and money expert at her family-run firm, O’Keeffe Financial Partners, located in Fairfield, NJ. Catch up on Select’s in-depth coverage of personal finance, tech and tools, wellness and more, and follow us on Facebook, Instagram and Twitter to stay up to date.
Editorial Note: Opinions, analyses, reviews or recommendations expressed in this article are those of the Select editorial staff’s alone, and have not been reviewed, approved or otherwise endorsed by any third party.