Tahoe-Truckee Market Beat: The importance of diversification
I’m sure you have heard the old saying, “Don’t put all of your eggs into one basket.” If you were to drop the basket, all of your eggs could break.
The investment term for using more than one basket is called diversification. Diversification is a very important concept in investing. To diversify means to spread your risk. If all of your money is tied up in one stock you’re exposed to individual stock risk. If you spread your holdings out by using a broad based index fund, you’ll still be exposed to market risk, but not single stock risk.
By adding bonds to your portfolio you can lower your exposure to market risk, but bonds have separate risks as well. Bonds are subject to interest rate risk and default risk.
Interest rate risk is the risk of rates rising, causing the value of your bonds to decline. Default risk is the risk of the issuer defaulting on the bond. Junk or high yield bonds can have high default rates during times of economic recession.
This year is a good example of how a portfolio of half stocks and half bonds can be less volatile than an all stock portfolio. Year to date as of February 5, the ETF that represents to Dow Jones Industrial Average, the Diamond, symbol DIA is down minus -8.22%.
The ETF that represents long term US Treasury bonds, the TLT, is up +8.03%. A portfolio of half DIA and half TLT would be essentially flat this year, while many stock indexes are down about 10%.
Adding asset classes that are not highly correlated to stocks can also be a good way to diversify at times. The gold and silver ETFs are both up over 10% year to date. Commodity funds can be good diversifiers, but many commodities go through long bull and bear cycles, and it’s important to pay attention to where their prices are relative to a long term average. Gold topped out in 2011 and is well below its all-time high; even though it has performed well so far this year.
Investors face many different types of risk and not all risks can be diversified away. Depending on an investor’s individual goals, portfolios can be structured so that they are not too concentrated in any one area.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.