You may have heard it before: A well-diversified portfolio is a key component of a successful long-term investing strategy. But what exactly makes a portfolio, well, diversified? More than you might think.
Here are the different categories to consider when building your stock portfolio.
Domestic vs. foreign
We all like to root for the home team, but it pays to invest in foreign players too. Your international stocks could hail from developed countries, like Canada, the U.K. and France, or emerging markets, like Brazil, Russia, India and China. (You might know this quartet by its investing acronym BRICs.) The former group tends to be considered safer, given their relative economic security; the latter offers more growth potential.
“Market cap” refers to the value of a company, calculated by multiplying the share price by the number of outstanding shares. Generally, small-cap is defined as less than $2 billion, large-cap is more than $10 billion and mid-cap is anything in between.
Typically, small-cap companies come with greater risks, as they tend to be younger and have less access to capital (aka cash). Plus, investors may have a harder time doing their due diligence because analysts are less likely to cover them, says Certified Financial Planner Marguerita Cheng of Blue Ocean Global Wealth in Rockville, Md.
At the same time, “with risk comes the opportunity to grow and create possible return,” says Certified Financial Planner Vid Ponnapalli of Unique Financial Advisors in Holmdel, N.J. “Small caps have more room for growth than large caps.”
Growth vs. value
A growth company churns out big profits and has plenty of cash to continue expanding. That can be very attractive for investors, as prices can soar, especially during bull markets. Alternatively, a value company’s stock is relatively cheap compared with its earnings and sales (exhibited by a low price-to-earnings ratio). Its stock price may have been dragged down by a news event or because similar stocks are down, for example. The stock offers willing investors a potentially big return if the price can bounce back. Ideally, you want both types when building a balanced portfolio.
Every company gets labeled according to what its business does. For example, Facebook and IBM are in the tech sector. Other sectors include financials, consumer staples, health care and real estate. Because companies in the same sector tend to perform similarly, it’s smart to spread out your holdings over a variety of categories.
And make sure you have stocks in both “defensive” and “cyclical” sectors. The former remains relatively stable in any type of market, while the latter could profit greatly from a particular economic environment. For example, Cheng says investing in building materials, construction and industrial companies during expansion periods might be opportunistic. On the other hand, consumer staples and technology tend not to be affected as much by market cycles. “Smartphones are no longer a luxury; they are a necessity,” she says.
What about bonds?
You’ll want a mix of bonds issued by corporations, states and municipalities (or “munis”) and the federal government (“Treasuries”), all of which have different risk levels and expected returns. Corporate bonds have the greatest potential returns—and the greatest risks. Since Treasuries are backed by the U.S. government, they’re considered relatively low risk. Munis fall in the middle.
You can also balance your bond portfolio by purchasing bonds with varying maturity dates. Short-term bonds mature in five years or less, intermediate bonds mature between five and 12 years and anything beyond is considered long-term.
Is there anything else I should know?
Beyond stocks and bonds, an investor might consider what are called alternative investments. That includes real estate, commodities, cryptocurrencies, even art and antiques—pretty much anything that doesn’t fit neatly into the stock or bond box. They’re usually considered more complex and risky, so new or casual investors often skip them while they attract a lot of attention from institutional investors and “high net worth individuals” (read: rich folks).
But mutual funds and exchange-traded funds (ETFs) make investing in alternatives more accessible to the masses. For example, both Vanguard and State Street offer real-estate-focused ETFs that invest in a variety of real-estate investment trusts (REITs). State Street also has a few commodities offerings, including a couple ETFs for gold and a couple for natural resources. These types of funds could be a good addition for you, if you’re looking to give your portfolio a little kick. But experts typically recommend limiting this type of investment to a small portion of your overall portfolio, perhaps as little as 5 percent or less.
There’s also cash. On the other side of the risk spectrum, cash and cash equivalents (certificates of deposit, money market accounts, money market funds) provide a bunker of safety for your portfolio. Just remember that little risk of loss means little chance of big returns, and you still have to think about inflation, which can eat away at your cash investments’ purchasing power. So you don’t want to be overly cautious and dedicate too much of your portfolio to this category.
What does a well-positioned portfolio look like?
It depends on several factors. Most importantly, an investor must consider their risk tolerance, risk capacity (how much you can afford to lose) and time horizon.
If an investor’s risk tolerance and capacity are high, and they are, say, 26 and saving for retirement or a long-term goal, they may benefit most from an aggressive portfolio. That could be around 90 percent stocks, including 30 to 35 percent international stocks, half of which might be in emerging markets, Ponnapalli says. For someone approaching retirement, he recommends scaling back but still investing heavily in stocks over bonds—perhaps a 70/30 mix. He also recommends dialing down the international holdings and exposure to emerging markets.
This seems like a lot of work. Can somebody else do it?
Actually, yes. In fact, it’s highly recommended. Trading individual stocks and bonds yourself to build and maintain a well-diversified portfolio requires a lot of research and possibly a lot of costs—more time and money than most individual investors would prefer to dedicate to investing. And getting it wrong could result in huge losses.
Investing through mutual funds and ETFs, on the other hand, taps experts’ knowledge and experience to do the real heavy lifting of portfolio-building. It also allows you to invest in possibly hundreds of companies in one fell swoop. (For instance, Acorns portfolios include a mix of seven ETFs with exposure to thousands of stocks and bonds.) Plus, funds—particularly ETFs and index funds—provide that broad diversification at relatively low costs. That makes investing and achieving all your financial goals as easy as possible.
Investing involves risk including loss of principal. Diversification does not guarantee against losses. This article contains the current opinions of the author, but not necessarily those of Acorns. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.