Ancient Chinese merchants were said to have developed a unique way to manage their risk. They would divide their shipments among several different vessels. That way, if one ship were to sink or be attacked by pirates, the rest stood a good chance of getting through. Thus, the majority of the shipment could be saved.
It’s similar to how you might travel with money. You don’t keep all of your cash in the same pocket. You keep some at the hotel, some in your wallet and so on.
Your investment portfolio may benefit from that same logic.
Diversification is an investment principle designed to manage risk. However, diversification does not guarantee against a loss. The key is to identify investments that may perform differently under various market conditions.
On one level, a diversified portfolio should be diversified among asset classes, such as stocks, bonds and cash alternatives. On another level, a diversified portfolio also should be diversified within asset classes, such as a diverse basket of stocks.
A diversified approach
For example, let’s say a stock portfolio included a computer company, a software developer and an internet service provider. Although the portfolio has spread its risk among three companies, it may not be considered well diversified, because all the firms are connected to the technology industry. A portfolio that includes a computer company, a drug manufacturer and an oil service firm, however, may be considered more diversified.
Similarly, a bond portfolio that invests exclusively in long-term U.S. Treasuries may have limited diversification. A bond fund that invests in short- and long-term U.S. Treasuries, plus a variety of corporate bonds, may offer more diversification.
Mutual funds and ETFs
The concept of diversification is one reason why mutual funds and exchange-traded funds (ETFs) are so popular among investors. Mutual funds accumulate a pool of money that is invested to pursue the objectives stated in the fund’s prospectus. The fund may have a narrow objective, such as the auto sector, or it may have a broader objective, such as large-cap stocks. ETFs also can have a narrow or broader investment objective. Keep in mind, though, that the narrower an investment objective, the more limited the diversification. Furthermore, a narrow investment objective may result in more volatility and additional risks associated with a particular industry or sector.
The concept of diversification is critical to understand when you are evaluating a portfolio. And investment always comes with a certain level of risk. Our Investment Services team is here to help you understand the risks and navigate the market.
We also offer quarterly educational seminars to introduce you to different aspects of investing, like our recent seminar about buffered ETFs. Watch for other upcoming seminars focused on various other investing topics and talk to our team to learn more.
Mutual funds and exchange-traded funds are sold only by prospectus. Please consider the charges, risks, expenses, and investment objectives carefully before investing. A prospectus containing this and other information about the investment company can be obtained from your financial professional. Read it carefully before you invest or send money. Shares, when redeemed, may be worth more or less than their original cost.
