Beware The Boom: Diversify Your Portfolio To Protect From The Bust

       

There’s always a “next big thing” in investing. In the early 2000s, it was Enron. In 2008, it was real estate. Seeing outlandish returns from high-performing sectors can lead investors to chase the herd and pour most of their capital into a narrow segment of the economy. It hasn’t worked out well in the past.

The most important protection you can provide for your portfolio is a diverse range of assets. While this seems straightforward, it can be difficult to put into practice. Let’s look at four ways you can diversify your holdings that may not be so obvious.

1.) A whole-market fund

Among the most popular investments is the whole-market exchange traded fund. These securities represent, roughly, a share of the entirety of a particular index. Rather than picking individual securities, you invest in a mutual fund that balances its holdings to capture the performance of an entire listing, like the S&P 500 or the Dow Jones Industrial Index.

These funds tend to be insulated from the gains and losses of specific companies. After all, if one company in a sector goes down, there’s more market share left over for its competitors. While that insulation doesn’t allow investors to reap all the rewards of an outlier security that’s performing well, it also protects investors from catastrophic loss of value. Think of it this way: The kind of economic disaster it would take to wipe out the 500 largest companies in the world would have much broader ramifications than your retirement portfolio, and even cash stuffed in your mattress would likely be worthless at that point.

Whole-market funds do well, historically, averaging around 6% growth a year. Some years will be up, and others down. However, over time, the trend line points upward. Whole-market funds are an easy way to diversify a portfolio.

2.) Diversify kinds of holdings

While a whole-market fund is a fairly diverse investment strategy, there are ways to balance the volatility of the stock market. Investing in a blend of asset classes, including bonds, provides security against the tumultuous nature of the stock market. Generally speaking, bonds are safer than stocks but offer less opportunity for growth. When stocks suffer, bonds tend to increase in value. So, holding a percentage of your assets in bonds will help protect you against the bumps in the stock market road.

What percentage of your assets should be in bonds is a difficult question to answer. It depends upon, among other factors, your age, how close you are to retirement, and your individual tolerance for risks. As a rough guideline, 100 minus your age is a good starting point. Your exact ratio will vary based upon your income and your estimated retirement age.

Like with stocks, it’s safer to invest in funds that buy lots of little pieces of bonds than to buy individual bonds yourself. Individual bonds can lose value because investors doubt the ability of the investor to pay it off. Diversifying your bond holdings provides a maximum of security.

3.) Diversify your income

If you lost your job, how would it impact your retirement plans? Most likely, you’d have to postpone retirement for a few years, depending upon how quickly you could find new work in your industry. What if you lost your job because of an industry-wide contraction, though? It might hurt more than your present income.

This doesn’t mean you should get a second job in an unrelated industry. Rather, be careful not to rely too much on stock in your employer’s company. If your company experiences tough times, it might have to reduce staff AND its stock price would fall. If you’re holding most of your assets in company stock, that could put you in a difficult position.

By all means, take advantage of matching funds and employee purchase plans. Be cautious when doing so, though, and be sure to keep your overall portfolio in line with your individual risk tolerance. You may like your employer, but that’s no reason to trust a single company with everything.

4.) Diversify your accounts

Even the perfect blend of stocks and bonds is still very susceptible to the ups and downs of the market. Suppose you have a sudden need for the money you’re saving for retirement. Perhaps you’ve experienced an emergency medical expense or other personal catastrophe. If all of your holdings are in an investment account, you might be forced to sell at a loss.

That’s why saving in a variety of places is important. Invest in your retirement account, but don’t neglect certificate accounts for mid- to long-term savings, and your share account for a rainy day fund. When your money is spread over a number of places, you can always have access to at least a portion of it when you need it.

Think of your savings like a garden. If you plant just one kind of seed, you’re out of luck if it doesn’t take. When you plant many different kinds of seeds, you have better chances to harvest fresh vegetables. The same is true of your investments. Putting your money in only one place is a risky strategy. Try to ensure all your bases are covered.

YOUR TURN: How do you protect your assets from the bumps and bruises of the economy? What diversification strategies do you use to keep yourself safe?