Diversifying your investment portfolio is an important step in building wealth, but what does it mean? A diverse portfolio is one in which your investments are not focused in one area of the market—i.e. one sector, or one type of company. A portfolio focused on one sector is more volatile: it will suffer severe losses if that sector plunges. A diversified portfolio can weather losses in one sector by spreading its investments across multiple areas of the market. That way, other investments can pick up the slack of the negative shares.
How, then, do you diversify your investments?
The complicated answer is to invest in various companies whose historical patterns of gains and losses differ. Of course, historical performance does not guarantee future performance. But investing in this way can help assure that while part of your investments are losing, there's a good chance that another part is winning.
That's not really an answer, though, because how is that done?
The real keys to diversifying a portfolio are more simple. Basically, you want to mimic what mutual funds do. In fact, the easiest diversification technique is to simply invest in mutual funds—collections of stocks that are traded by a professional—and index funds—mutual funds that invest strictly in a specific stock index. The funds are created by professional brokers and, therefore, are already diversified.
But for the trader who wants the most control over their investments, here are some tips to diversify your investments on your own.
The various characteristics to take into account include: type of investment, market capitalization, geography and sectors. If your investments include mutual funds, diversify those by taking their styles into account (growth, growth/value, value). It is also important to balance stocks, bonds, funds and other short-term investments.
Market capitalization, or market cap, is an indicator of a company's size. It is the value of its outstanding shares, calculated by multiplying the number of shares by the current price per share. Diversifying between large-, mid- and small-cap companies ensures a range of company sizes that often respond differently to the market. Large-cap companies usually have a market cap exceeding $10 billion, while small-caps are under about $2 billion. Large cap companies are generally steadier investments, though they might not bring in huge gains, quickly. Conversely, small-cap companies are considered more volatile, which could boost gains (yay!) or losses (no!).
A sector in the stock market represent a part of the economy containing businesses with similar products or services. The markets are divided into sectors such as energy, consumer staples, health care, financials, utilities and industrials, among others. Sector diversification is easy to accomplish: don't invest all of your money into cars, or health care companies, or tech companies, or retail companies. Choose a selection of stocks from different sectors to avoid collapsing when a sector reports big losses.
You might think about this one less, but geography is another important aspect of your portfolio. Investing internationally might sound frightening, but a professional can help you secure promising international stocks and funds that could be a safeguard against domestic losses.
Another interesting point about geography: it could be disastrous to invest too much of your money in local companies. It's natural that you would want to buy shares in companies that you know, trust and want to support. But consider what would happen if the manufacturing company that's a large employer in your area suddenly suffers big losses. If you work there, you could be facing unemployment. If you're a shareholder, you could also be facing a heavy loss in your investment. Safeguard yourself from a situation like this by spreading your investments geographically, as well as by industry.
Finally, don't forget to check up on your strategy. Just as important as initial diversification is revision. Find what's working, what's not, and adapt. Set a checkup schedule to avoid emotional bias (we all want to check when we're doing the best and the worst, but those are not ideal decision-making times). Regular evaluations can make sure that your successful strategy stays successful.
There is no perfect set of rules for creating a winning portfolio. And anyone who follows the news knows that the markets often do exactly what no one is predicting, what they're not supposed to, what would never happen based on past performance. But a patient, diversified approach to portfolio-building is the best chance of success investors have.
As a last piece of advice: consider professional help. People make their careers out of investing; let them help you build your portfolio. There's a very good chance the payoff will be worth the expense.
- 5 Tips For Diversifying Your Portfolio | Investopedia ›
- Simulator How-To Guide: Diversified Portfolio | Investopedia ›
- Guide to Diversification - Fidelity ›
- How To Diversify Your Portfolio Using Only Stocks | Stock News ... ›
- How to Diversify Your Investments -- An Easy Rule of Thumb | Nolo ... ›
- Cramer: Forget sectors! A better way to diversify ›
When you take out a loan for a car, charge something to your credit card, or get a personal line of credit, there is going to be an interest rate that applies to your loan.
A lot of different factors go into what you will be charged, including your own personal credit score. But even those with flawless credit still see a minimum charge that they can't get around. That all goes back to the Federal Funds Rate.
One thing consumers rarely realize is that all of our banks are lending money to each other every night. Banks are legally required to maintain a certain percentage of their deposits in non-interest-bearing accounts at the Federal Reserve to ensure they have enough money to cover any withdrawals that may unexpectedly come up. However, deposits can fluctuate and it's very common for some banks to exceed the requirement on certain days while some fall short. In cases like this, banks actually lend each other money to ensure they meet the minimum balance. It's a bit hard to imagine these multibillion-dollar financial institutions needing to borrow money to tide them over for a bit, but it happens every single night at the Federal Reserve. It's also a nice deal for those with balances above the reserve balance requirement to earn a bit of money with cash that would normally just be sitting there.
The Federal Reserve
The exact interest rate the banks will charge each other is a matter of negotiation between them, but the Federal Open Market Committee (FOMC) (the arm of the Federal Reserve that sets monetary policy) meets eight times a year to set a target rate. They evaluate a multitude of economic indicators including unemployment, inflation, and consumer confidence to decide the best rate to keep the country in business. The weighted average of all interest rates across these interbank loans is the effective federal funds rate.
This rate has a huge impact on the economy overall as well as your personal finances. The federal funds rate is essentially the cheapest money available to a bank and that feeds into all of the other loans they make. Banks will add a slight upcharge to the rate set by the Fed to determine what is the lowest interest that they will announce for their most creditworthy customers, also known as the prime rate. If you have a variable interest rate loan (very common with credit cards and some student loans), it's likely that the interest rate you pay is a set percentage on top of that prime rate that your lender is paying. That's why in times of low interest rates (it was set at 0% during the Great Recession), a lot of borrowers should go for fixed interest rate loans that won't increase. However, if the federal funds rate was relatively high (it went up to 20% in the early 1980's), a variable interest rate loan may be a better decision as you would be charged less interest should the rate drop without the need to refinance.
The federal funds rate also has a major impact on your investment portfolio. The stock market reacts very strongly to any changes in interest rates from the Federal Reserve, as a lower rate makes it cheaper for companies to borrow and reinvest while a higher rate may restrict capital and slow short-term growth. If you have a significant portion of your investments in equities, a small change in the federal funds rate can have a large impact on your net worth.
Whether you're leaving a job involuntarily, departing for something new, or just want to prepare for the unknown, it is smart to understand all your options regarding your 401k.
Frugal gifting often gets a bad reputation. However, this shopping method does not make you cheap — it makes you practical. Frugal gifts often avoid waste and overspending and can be just as meaningful (if not more so) as any other present.
With the National Retail Federation predicting each consumer this holiday season to spend upwards of $1,000 on holiday gifts amidst an economic recession —this year might be the perfect time to reconsider your spending budget. We've formulated the ultimate list of frugal gift-giving ideas to get you started.