Listening to some of the greatest investors of our time, you’ll often hear them talk about putting money into an index fund, like the S&P 500, to diversify across a broad set of businesses. But why does that matter? Why not just buy a set of stocks like Apple or Google?
The simple reason is that diversifying your portfolio can help spread losses across a variety of investments as opposed to just one. For example, I remember buying a shipping company stock back in 2011. It wasn’t a large amount, but at the time I thought that it was a good investment. However, some bad news came out about the shipping industry (too much capacity leading to lower prices) and the company specifically (it had too much debt that was affecting cash flow). Long story short, the company went bankrupt, and I lost my ENTIRE investment.
Now, compare that to owning an index fund that invests in the S&P 500 (a broad set of stocks). If a company in that index went bankrupt, you wouldn’t lose your entire investment.
Lesson learned for me: diversification is important for the individual investor. If you’re a professional investor, such as Warren Buffett, who can put a lot of money into a few companies that you know very well, then that is all the diversification you need. Otherwise, there are many benefits to diversification.
Why diversification matters
One of the main principles of investing is diversification. Put simply, diversification is the practice of spreading your investments around so that you limit the amount of exposure you have to a single asset class. There are several schools of thought on diversification. Research has shown that having a more balanced portfolio over time produces greater returns than ones without.
Many successful investors have learned to balance their portfolios based on their comfort with risk. For example, investing too conservatively at a young age can hamper growth of your investments, while being too aggressive while older could leave you overexposed to unnecessary risk.
To help balance risk and reward, diversification of assets is key. There are many complex ways to do this, but I believe there are four steps you can take twice a year that will ensure your portfolio stays diversified.
Like GEICO, 15 minutes can help your portfolio for the next 15 years (if not more!).
Step 0: Open an investment account
Before diversifying your portfolio, you’ll need a portfolio to diversify. This sounds like a simple step, but there are a lot of folks who don’t know how to establish a portfolio or are nervous to do so.
There are several low-cost (some brokerages have no minimum deposits, so you could start with $1 to fund your account) options available today. Some of my favorites are Wealthfront and Schwab. M1 Finance is another great robo-advisor to consider with 0% management fees.
Step 1: Determine your asset allocation
This will depend on your age and risk tolerance. However, an easy rule of thumb to remember is 110 – your age = amount in stocks.
This means for a 30-year-old, you should aim to have 80 percent of your investments in stocks and the remainder in bonds.
You may change this based on your risk tolerance (perhaps 35 percent in bonds), but this is a good starting point. This formula will allow your portfolio to grow in a way that may mirror your risk tolerance. As a younger person, you will want to be more risk-seeking in your portfolio through a larger allocation to stocks, which have more potential for appreciation and you have time to recover a market correction or crash.
On the flip side, that would mean there is more potential for a downside, i.e. if another 2008-2009 financial crisis happened and you had a lot of money in stocks, you would have lost approximately 25 percent of your portfolio. If you were older and wanted to protect more of your capital, the allocation should be weighted more towards bonds, which have less potential for appreciation, but are more stable and can provide an income stream via coupons.
As you continue to expand your portfolio, diversification expands from simply stocks and bonds. You can add things like commodities (gold, silver), real estate (commercial or residential) or even currencies.
Step 2: Pick your funds (or let someone do it for you)
The best bang for your buck is going to be low-cost index funds that allow you to track the broader stock and bond market. They have low fees, and because they track broader market indices means you get savings in the long run. Over time, index funds have become one of the best ways to lower your potential expenses, which helps your overall portfolio grow. You can read more about index funds (and how they differ from other funds), if you’re interested.
A few easy funds to choose from are from Vanguard, which has been at the forefront of passive investing for some time. There are several portfolios you can check out at Bogleheads, which is a wiki for passive investing. Two solid general ETF funds from Vanguard are VTI (follows the US stock market) and BND (follows the US bond market). Just these two funds can give you a fully diversified portfolio.
The other option is to use a robo-advisor like Wealthfront or M1 Finance, and let it pick for you. Based on your risk tolerance (they have a very easy way to calculate based on some questions they ask), Wealthfront will create a portfolio of index funds and invest on your behalf based on your questions you answer about your tolerance to risk and financial health.
Step 3: Set up automatic recurring investments
Set it and forget it. To help grow your wealth, you are going to need to pay yourself first. Instead of putting money towards non-essential items, you should always take some percentage of your pay and set it aside for investing. That percentage can vary based on individual circumstances.
I like to use 20 percent as a baseline and then adjust based on what is going on in life (kids are expensive!). Having the discipline to set aside a portion of your earnings will help in the long run with investing.
Once you decide on the right amount to set aside, you can set up automatic investments and have a regular deposit put into your investment account (across your own allocation).
If you use a robo-advisor, it will auto invest for you. This is my favorite way to invest: putting money aside and letting an algorithm that is probably smarter than me (over the long run at least) do the investing for me. It helps free up a lot of mental capacity to do other things like starting new businesses or spending more time with family. The amount of time I spend thinking about what index fund I should pick likely isn’t going to be the best use of time since my investment horizon is 20+ years.
Your plan advisor will have options for you to reinvest dividends, keep the allocation consistent, and harvest tax loss options as well. Each brokerage has its own set of options for investment, services they offer, and fees they charge. For example, Personal Capital has its own set of options for accounts based on the value of invested assets and offers.
Good luck in your quest! Investing has been a journey, and it all started with a single step. Leave a comment with any suggestions you have for diversifying your own portfolio!
Derrick Deese got started investing when he was 18, buying Starbucks stock. He is still kicking himself for not holding it, but has learned a lot since then. He’s passionate about investing, financial freedom, and photography. He works in marketing and lives with his wife Natalie in Seattle.