by Richard E. Reyes, CFP
The word diversification, as well as, asset allocation, are common financial terms that are often misused and misunderstood by both investors and the financial industry itself.
The real news is that when it comes to building a portfolio, especially one with exposure to equities, you do not need any of the traditional investing methods of market timing, speculating and gambling, and/or stock picking. As an investor you must understand that the real substance in building a solid portfolio relies upon diversification and asset allocation. This is extremely important to understand because over and over it has been proven that approximately 92% of a portfolios return is determined by asset allocation while less than 7% of returns are attributed to stock picking and market timing. That means that you should disregard much of what you see in the media or what is touted by most of the financial industry regarding investments.
So what does diversification mean? In simple terms it means spreading your assets over a variety of different investments, however, to be truly diversified means much more than that. Real and proper diversification is based upon maximizing your return potential while minimizing your volatility (or risk). Next to compound interest; it’s your true friend.
Let’s look at an example of how it works. Simply owning a lot of stuff does not mean you are diversified. For example, you could own 50 U.S. Blue Chip stocks. If they are all in the same asset class or even industry you do not have true diversification. Let’s say all the 50 stocks you own are all Blue Chips and the S & P 500 drops 20%, it’s very likely your portfolio will also decline because you own all similar stocks. Very few investment portfolios are truly diversified.
Another common mistake that I notice with investors is that they may be invested in several mutual funds with different names and objectives or the top performing funds which make them believe they are diversified. When the markets drop, to their horror when they lose A LOT of money. This is because “What You See is Often Not What You Get.” When it comes to active and portfolio management, many funds give their portfolio managers the freedom to buy whatever they think will be the next big thing. Which leads to those mutual funds all buying and chasing the same stocks and therefore very little diversification. So its very important that you maintain the correct investment philosophy.
When it comes to true diversification its being different from your friends’ and neighbors’.
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Wealth and Business Planning Group, LLC (The Financial Quarterback™) is a Registered Investment Advisor in the State of Florida that provides Fee Planning and Asset Management. Depending on your state of residence, Wealth and Business Planning Group, LLC (The Financial Quarterback™) may not be able to immediately provide services. For more information go to www.thefinancialqb.com. Richard E. Reyes, CFP is an Investment Advisor and President of Wealth & Business Planning Group, LLC (The Financial Quarterback™).