Hey Bow Tie Nation, we’ve talked about diversification here on Let’s Talk Money in the past, it’s an idea that can save your portfolio…if most investors weren’t doing it ALL wrong!
The problem is, most investors aren’t diversifying their portfolio by adding more stocks, they’re just making it worse…they’re de-worseifying it!
Just adding more stocks to your portfolio, you end up limiting the return you can get and putting yourself at risk for the worst of a stock market crash. In this quick video, I’ll show you how to truly diversify your portfolio in less than five minutes. I’ll reveal step-by-step to lowering your risk without limiting those returns!
2 Reasons Why Diversification Can Go Wrong
Now, there are actually two reasons diversification goes wrong. First is investors end up buying too many stocks. Flip on the TV or your favorite website and you’ll get five stock picks an hour, pitching you the next hot trend.
Pretty soon, you’ve got a portfolio of 50-plus stocks and no chance in hell of outperforming the market. Think about it this way, if you have an equal amount in each of those 50 stocks, that’s about 2% of your portfolio each. Even if one of those stocks doubles, it’s only adding 2% to your overall return. To get any kind of a return, most of your stocks have to outperform and what are the odds of being able to pick 50 great companies?
Research has shown that you completely diversify your portfolio with as little as 20 or 30 stocks. In other words, if you’ve got more than 30 or 40 stocks then beyond that point you’re just limiting your returns.
Instead, aim for just 15 to 20 individual stocks in your portfolio. Now you can invest in a few funds as well to spread the risk but limiting yourself to that handful of individual stocks really keeps you picky about which ones you buy. You end up with only the very best of the best companies.
The other way diversification goes wrong is investors have all their stocks in one sector or theme and they all crash at the same time. Imagine it this way, even if you had 100 tech stocks which you think would save you from problems at any individual company, what do you think is going to happen to all 100 of those companies in a major tech crash? So not only are you losing any chance for a higher return because you have so many stocks, but it’s also not protecting you like you thought because all those stocks are crashing together.
Fixing these two problems is going to help you lower the risk in your portfolio but keep that potential for higher return.
How to Save Your Portfolio the Fast Way
Here’s how to make sure your portfolio is truly diversified and you can do it in five minutes.
First, you want to make sure your portfolio is diversified by asset class.
An asset class is a broad group of investments that share similar drivers for price and risk. For example, stocks do well with moderate inflation and follow economic growth as well as being easily bought and sold. Bonds on the other hand do poorly against inflation and tend to fall with higher economic growth because of higher interest rates.
And Nation, I know talking bonds and other asset classes isn’t as sexy as finding the next hot stock pick but this right here WILL make you a better investor and help you earn those higher returns!
So look at your portfolio and figure out how much you have in each asset class; stocks, bonds, real estate and even crypto. If your answer is 100% in stocks and zero in the rest…yeah, that’s not good.
How much you want in each is going to depend on your age, tolerance for risk and need for return but having at least a little in two or three of these is going to not only protect you from any market crashes but will give you the opportunity to buy back into stocks at lower prices when everyone else is panic-selling.
For a quick idea of how much to have in each; you can take 110 minus your age for the amount to have in risky and safer investments. For example, for me, 110 minus 45 would mean I should have about 65% of my portfolio in riskier assets like stocks, crypto and maybe some alternatives like startup investing. Then with that other 35% I put that in safer, diversifying assets like bonds and real estate.
Using this method, youre portfolio is gradually going to get safer, going to shift to the lower risk in bonds and real estate as you get older and closer to needing that money.
We’ll get to that second step next but I want to get your opinion on this as well. How do you look for problems in your stock portfolio? How do you know when it’s time for a change? So scroll down and let me know in the comments below, how often do you change your portfolio and why?
Second here, we’re going to make sure you’re diversified within your stocks as well.
You see the 11 stock sectors here and these are just sectors of the economy that produce a common service or need like utilities, energy and healthcare. Just like the asset classes, each sector responds differently to factors in the economy and the market so spreading your stocks around a little is going to help protect your portfolio.
For example; stocks in Utilities and Consumer Staples tend to be safer because these are things people need to buy. They also do well when interest rates fall because it makes those dividend payments more attractive. On the other hand, stocks in the Energy, Materials and Financials sectors do better when interest rates rise and with a little higher inflation.
The idea here is that whatever causes the next big stock crash, whether it’s interest rates or inflation, or a popped bubble in a group of stocks…it’s not going to hit all stocks the same. It might mean tech stocks plunge but that other part of your portfolio in bank stocks or miners won’t get hit as hard.
So what you want to do is add up the dollar amount for all your stocks by sector. If you don’t know what sector a stock is in, you can click on the Profile tab here in Yahoo Finance. You’ll see along the top here the sector and industry the company is in.
And doing this, adding up all your stocks in each sector, is going to be a real eye-opener for a lot of investors. A lot of you might find out just how much you have in one or two sectors without even knowing it.
Bonus Tip to Save Your Portfolio
But that’s what we’re here for, to help you create a better portfolio that won’t get destroyed with a market crash.
Now you don’t really need stocks in every sector but you should have exposure to at least four or five of the 11 stock sectors. Pick five sectors you think could do well and then you’re going to make a list of best of breed stocks, maybe two or three stocks in each sector. Here’s a table of how much each sector makes up the overall market, the percentage of the stocks in each sector are of the S&P 500 index. You can see it’s a little overweighted to tech stocks, healthcare and consumer discretionary but spread out across all 11 sectors. You also see examples of Vanguard and iShares funds that cover each sector.
For ideas on which stocks are in each sector, we can go here to the tracker on SectorSPDR.com and all you out there in the Nation are going to recognize this because it’s a great resource for following returns by sector. But you can click on any of these and see all the S&P 500 companies, the 500 largest companies based in the U.S. and which sector they’re in.
Again, with just 10 to 20 stocks total, you still give yourself the opportunity to find those breakout success stories that will take your portfolio higher. You’re not spreading your portfolio out across too many stocks and are only in the very best, but because you’ve also got that risk spread out across different sectors, all your stocks won’t fall together when the next crash comes.
Nation, spend this five minutes to fix your portfolio and it will pay off. It’s an easy fix that will protect your from the worst selloffs helping you to keep the return… not the risk.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.