Expert Guidance: Create a diversified portfolio With Don Kittell, Chief Financial Officer, Securities Industry and Financial Markets Association Create a diversified portfolio "Don't put all your eggs in one basket" may sound old fashioned, but it still remains sound advice in investing. Diversification is perhaps one of the most important tools available to investors to reduce the overall risk within their portfolios.

When you diversify, you invest in different securities within the same asset class, such as stocks, bonds, and cash equivalents. Diversifying within an asset class — for example, within stocks you might choose to own a dozen large company growth stocks, a handful of small company value stocks, and an S&P 500 Index fund — can help smooth out the returns within a particular sector of your portfolio.

The weakness of any discussion about diversification is that there is no one right answer as to what makes up the perfect portfolio. Each of us has to decide the appropriate level of diversification given the cost and timing of our goals and our risk tolerance. I have always been overweighted in stocks because I believe in them and my horizon is still long-term. But within the stock category I have diversified with different types of stocks and mutual funds.

But that's just me. Your circumstance could be remarkably different.

Throughout the rest of your journey through diversification, you'll develop the knowledge you'll need to select the kinds of investments that will help you meet your investment goals while taking on the level of risk you're comfortable with.

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What is diversification & riskDiversification means creating an investment portfolio that contains different types of investments within each of the major asset classes — stocks, bonds, and cash. A diversified portfolio might include stock in several different companies or a number of stock mutual funds, government and corporate bonds, and U.S. Treasury bills. You might diversify a larger portfolio even further by including a range of investments from other asset classes, such as real estate or options.

When you diversify, you choose between different subclasses of investments within each asset class. Each subclass is similar to other investments in its class, but also has some distinctive characteristics. For example, the stocks of large and small companies are both equity investments. But the two tend to increase in value at different rates and expose you to different levels of investment risk.

Finally, each subclass is made up of hundreds, and sometimes thousands, of separate investments for you to choose among. For example, the stocks of the five hundred companies included in Standard & Poor's 500-stock Index are usually all considered part of the subclass of large-company stocks.

In some ways, it's easier to understand diversification by explaining what it is not:



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Reasons to diversifyThere are two important reasons to diversify your investment portfolio:
Taking advantage of different markets

Each of the traditional asset classes — stocks, bonds, and cash — tends to produce its strongest returns under different market conditions than the other asset classes do.

For example, stocks often shine when corporate earnings are strong and financial markets are expanding. Yet this same environment frequently has the opposite effect on bonds, so that they provide lower than average returns.

On the other hand, bond returns often rise in a period when stock values drop. That may happen when interest rates go up or when corporate earnings don't meet investor expectations. If you have some money in both stocks and bonds, you'll be in a position to benefit from owning the one that's up, while limiting your losses on the one that's down.

Protection against downturns

If your investments are narrowly focused — for example, if you own stock in just one company or stock in three companies in the same industry or area of the economy — the value of your portfolio can drop sharply if that company or industry provides disappointing returns. But if you own stocks of different-sized companies in different parts of the economy, even if some investments go down in value, others may remain stable or go up. In any case, different types of stocks are not as likely to lose value at the same rate or at the same time.

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Diversification & risk If you diversify, you may be able to protect your portfolio against some of the risks of investing without giving up the level of long-term return that you're seeking.

That's possible because different subclasses within an asset class carry different levels of risk — sometimes referred to as risk-to-return profiles . If you select different investments within a number of subclasses, your portfolio of investments, as a group, can balance, or offset, the risk that any one investment might pose individually.

For example, the possibility of frequent or sudden changes in the value of a small company stock might make it a risky investment if that stock makes up a large percentage of your portfolio. But if your portfolio also includes blue chip stocks, the picture changes.

That's because the generally greater stability of the blue chips can help your portfolio maintain its value even if the small-company stock takes a nosedive but the stock markets overall are strong. At the same time, the growth potential of the small company stock can help balance the typically slower growth of the blue-chips.

Remember, the more narrowly focused your investments, the less diversified you are. And that can leave your portfolio more vulnerable to sudden swings in value — and increase your risk for significant losses.
From the expert
Don Kittell explains how diversification helps minimize certain types of risk.

The unique risk of an asset is known as unsystematic risk. This is the risk that characterizes only one individual asset, and it is a risk that can be eliminated through diversification. For example, the risk that the management of the ABC Corporation will make strategic blunders is unsystematic risk. Only ABC's managers have the ability to make internal decisions that can ruin the company's future. The managers of XYZ Co. have the ability to give their shareholders palpitations, but are likely to have very little influence on what happens at ABC, unless they are a direct competitor.

Risk that cannot be diversified away is known as systematic risk. This risk is inherent in all assets. It is caused by macroeconomic factors and will remain even in a diversified portfolio of assets. For example, a nationwide recession will affect most companies and is therefore considered systematic risk.

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How do you diversify Diversification isn't just about increasing the sheer number of your investments. It's about striking a balance among various investments in your portfolio to reduce your exposure to risk and take advantage of the full range of opportunities in the market. First, you need to analyze what you already own before you make another investment. Then you can identify the category or categories within an asset class that you need to build up.

For example, if you own only long-term U.S. Treasurys in your bond portfolio, you may decide to purchase municipal bonds or short-term corporate bonds next. The municipals provide tax-free income, while the short-term corporates provide greater inflation protection.

Or let's say all of your stock investments are in large, blue chip companies. Then it may be time to investigate some smaller company stocks, since they tend to perform differently — and rise and fall in value at different times — from larger company stocks. In this way, you can offset some of the risks that each investment carries on its own, while enjoying many of the advantages and benefits of each category of investment.

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Assessing your goalsAs you diversify your portfolio among different subclasses, or categories, of investments, you need to take your individual financial situation and goals into account.

For instance, let’s say you’re planning to sell some of your investments in the near future to pay for your daughter’s college tuition. You’d want to think twice before investing your income-producing assets in long-term bonds, or seeking your growth in extremely volatile investments, such as small-company stocks.

On a different note, let’s say you have a guaranteed pension to look forward to when you retire. In that case, you may be able to pursue a more aggressive strategy in your personal portfolio, including small company stocks and perhaps some higher-yielding corporate bonds — especially if your retirement is still a ways off.

But if your retirement is only a few years away, and you’ll be dependent on your portfolio as a substantial source of income, you may want to diversify your portfolio with typically more stable, income-producing investments, such as blue chip stocks, top-rated corporate bonds, municipal bonds,and Treasurys.

There’s no ideal diversification formula that’s right for everyone — it depends on your goals, your financial situation, and your tolerance for risk.

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Choosing individual investmentsAs you diversify you need to evaluate your investments — and your potential investments — on their own merits, as well as what they bring to your overall portfolio. It's not enough that an investment is in the right asset class or subclass — you'll need to make sure that the investment you choose has the best chance of helping you meet your financial goals. This means doing your research before you invest, as well as reviewing your portfolio from time to time to make sure that all of your investments are meeting your performance expectations.

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Diversification tips Many investment experts agree that you can build a diversified portfolio if you:


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Stocks: Industries & sectors When you invest in stocks, or stock mutual funds, you want to consider spreading your portfolio across a variety of industries or areas of the economy. Diversifying across different industries can help protect your portfolio from downturns in stock prices in a specific industry or sector of the economy that is not in step with the overall direction of the market.

For example, your stock portfolio could lose value if it is heavily weighted in telecommunications stocks, and the prices of those stocks drop dramatically even though the overall market is rising. Because it's impossible to predict the economic, political, or market factors that may effect the fortunes of any one industry or sector of the economy over the short term, it's important to make sure that your portfolio is never narrowly concentrated.

Different types of stocks tend to perform well in different market conditions. Cyclical stocks, for instance, are those that have a tendency to rise in value in a strong economy and fall during an economic downturn. These include airlines, automobile, and travel and leisure stocks. In contrast, stocks in industries that provide necessities — sometimes called countercyclicals — such as food, gas, and electricity tend to remain more stable in value regardless of market conditions.

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Market capitalization When building a portfolio of stocks, or stock mutual funds, it's important to take into account how the market capitalization, or market cap, of the stock you're considering fits into your overall strategy.

Market cap — or market value as it's sometimes called — is one way of measuring the size of a company and anticipating its investment potential. Market cap is calculated by multiplying a company's current stock price by the number of its existing shares. For example, a stock with a current market value of $30 a share and a hundred million shares of existing stock would have a market cap of $3 billion.

One size doesn't fit all

Stocks are usually categorized as large-cap, mid-cap, and small-cap. Some experts also use a special category for very small cap stocks, called micro-cap. You'll want to consider diversifying your portfolio among stocks with different market caps, since stocks of different sizes tend to perform differently in the market. For instance, smaller cap stocks may go up in value at the same time the values of large-cap stocks remain flat or go down, or vice versa. And following a period in which one category outperforms the other, the situation typically reverses.

In general, large-cap stocks tend to be less volatile than small-cap stocks. This is because small-cap stocks generally represent younger, less established companies that do not have the financial resources of larger companies and are thus more vulnerable to failure.

As you might expect, mid-cap stocks can offer a middle ground between the growth potential of small-caps and reduced volatility of large-caps. Mid-caps also typically cost less than large-cap stocks, but are less vulnerable in economic downturns than small-caps.

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Growth & value You'll also want to try to strike the right balance between stocks that produce growth and stocks and other investments that provide value. From an investing perspective, growth is the increasing value of an investment over time. Stocks of companies that reinvest their profits rather than paying them out as dividends are considered growth investments. So are stocks of young, fast growing companies.

A popular indicator of a stock's growth potential is its price-to-earnings ratio, or P/E. Calculated by dividing a stock's current share price by its earnings per share, the P/E — or multiple — can help you gauge the price of a stock in relation to its earnings. For instance, a stock with a P/E of 15 is trading at a price 15 times higher than its earnings.

While a low P/E may be a sign that a company's earnings are down and it is a poor investment risk, it may also indicate that a company is undervalued by the market because its stock price doesn't reflect its earnings potential. These are called value stocks, since their relatively low prices can make them a good value for investors — provided a company can turn itself around or is poised to expand.

You'll also want to look at the price and earnings of a stock in relation to its net asset value, or book value — a company's net assets divided by its number of outstanding shares and bonds. This information, which you can find in the reports of research companies that analyze stock investments or in the company's annual report, can help you gauge how much debt a company is carrying. Too much debt can limit growth potential.

It can be smart to have both value and growth stocks in your portfolio, since they can both produce strong results — or falter — but rarely at the same time.
From the expert
Don Kittell explains how many stocks you'll need to be diversified.

Studies have shown that a well-diversified stock portfolio should contain roughly thirty stocks: In an all-equity portfolio, the maximum benefits of diversification are reached when the portfolio contains thirty different companies' stocks. Do you have to own that many? Apparently not. Other studies indicate that most of the benefits of diversification can be achieved from portfolios containing twelve to eighteen stocks. I would certainly feel secure with eighteen, but others may want a broader spread.

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Types of bonds When you invest in bonds you can choose among four major subclasses: corporate bonds, U.S. Treasury bonds, agency bonds, and municipal bonds.

All these bonds promise to repay your principal with interest, which is why bonds are often described as fixed-income investments. But buying bonds from different categories of issuer lets you balance the potential inflation and investment risks that each type poses with the advantages it can bring to your portfolio.

For example, corporate bonds tend to pay higher rates of interest, providing a higher yield, than most of the bonds issued by governments and agencies, so they provide more income. But some corporate bonds may put your principal at risk. And the interest that corporate bonds pay is always taxable at your regular income tax rate.

In contrast, you never owe federal income tax on municipal bond interest, and you don't owe state or local tax either if you live in the state or city that issued the bond. But most municipal bonds pay interest at a lower rate than corporate bonds with similar levels of risk.

If you're looking for the highest level of security, you might decide to add U.S. Treasury bills, notes, or bonds to your portfolio. While government bonds typically pay less interest than corporate or agency bonds, you can be sure you'll always receive your interest payments and get your principal back on schedule. And as a middle ground between Treasurys and corporate bonds, you might add agency bonds to your portfolio.

Agency bonds are sold by various government-sponsored agencies, pay slightly higher interest than Treasurys but enjoy almost the same level of security. Agency bond interest is taxable. And sometimes rather than receiving your principal back in a lump sum, a portion of your principal is returned with each payment. That amount is not taxable.

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Bond terms When you're building a portfolio of bonds and bond mutual funds, you'll want to consider buying bonds with different terms. The term is the length of time between when a bond is issued and its maturity date, the date the par value of the bond is scheduled to be repaid.

The good news is that bonds are available in a variety of terms, from short-term U.S. Treasury bills, which currently come in 4-, 13-, and 26-week terms, to long-term bonds with maturity dates as long as 30 or 40 years. There is also a wide variety of intermediate-term corporate, government, and agency notes to choose from, which usually mature in two to ten years. In general, the longer the term the higher the rate of interest the bond pays to offset the risk you're taking in tying up your money.

One advantage of owning bonds with different terms is that you can use the principal that's repaid at maturity to take advantage of new investment opportunities as they arise. You can also choose maturity dates to coincide with a time you Know you'll need cash for a planned expense, such as a tuition payment or the down payment on a home.

If you stagger the maturity dates on bonds of the same term, an approach known as laddering, you can avoid having to reinvest all of your money at a single rate.

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Bond ratings Independent agencies, such as Standard & Poor's and Moody's Investors Service, rate the likelihood that corporate or municipal bond issuers will meet a bond's interest payments and repay your principal at maturity. They base their decisions on the issuer's past track record, its revenues or profits, the state of the economy, the industry and sector, and a host of other factors. U.S. Treasurys are not rated — they're considered absolutely safe, since they're backed by the full faith and credit of the federal government.

The various ratings systems have slight differences, but generally include 10 categories, ranging from a high of AAA (or Aaa) to a low of D. The lower the rating, the higher the interest rate the issuer usually pays on the bond in order to attract investors, but the greater the risk of default. The top three or four ratings are considered investment grade, and pose virtually no risk of default.

You'll need to be willing to take on a lot of risk if you plan to invest in very low-rated bonds. Otherwise known as junk bonds or high-yielding bonds, these are highly speculative investments.

However, as you build your bond portfolio, you may want to offset your low-yielding Treasurys with higher-yielding corporate bonds. If your bond portfolio is otherwise well diversified, you might even consider putting a small portion of your bond portfolio into something quite speculative.

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Cash for liquidity While stocks and bonds can help you meet your future needs — whether they're four or forty years off — your cash portfolio can help you provide for your immediate goals, be prepared for unforeseen emergencies, and take advantage of unexpected opportunities.

What cash and cash equivalents, such as certificates of deposit (CD) and money market accounts, provide that other investments don't is liquidity — the ability to quickly and easily convert your investment to cash without the risk of losing a lot of money. Some cash investments will offer you greater liquidity, such as check-writing privileges and instant access to your cash, while others will yield higher rates of interest but give you less liquidity. In general, the more liquidity the investment offers, the lower the rate of interest it pays.

It's a good idea to diversify your cash among a range of investments, with different levels of liquidity or different maturity dates, and paying different rates of interest. Diversification may allow you to achieve the best balance between the convenience and safety of liquidity with interest income from your cash investments.

For example, rather than putting all of your cash into a single CD or U.S. Treasury bill, you'll give yourself more flexibility if you stagger — or ladder — several CDs or Treasury bills with different maturity dates. Or you might combine the flexibility of a low-yielding money market account with a long-term, high-yielding CD.

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FDIC insured
Many cash investments offer the added security of being insured. High-yielding bank accounts and time deposits, such as money market accounts and certificates of deposit respectively, are both insured by the Federal Deposit Insurance Corporation (FDIC) to a limit of $100,000 per depositor. Money market mutual funds, on the other hand, are not insured by the FDIC — although a few fund companies provide private insurance. But depending on the company that offers the fund, the risk of default may be negligible. U.S. Treasury bills aren't insured either, but they are backed by the federal government, which can raise taxes to repay what it owes.

As you diversify your cash investments among savings, money market accounts and funds, CDs, Treasury bills, and other short-term investments, you'll want to weigh the absolute security of insurance against the drawbacks of lower yields and potential fees.

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Diversifying with mutual funds
It takes time — and money — to diversify a portfolio, since your goal is to spread your assets among a variety of different investments. Unless you have a lump sum to invest, you'll have to accumulate the money to pay for each new investment you want to make.

That's one reason why people who want to diversify, but have a limited amount to invest, may choose mutual funds. All funds own a number of investments, and some funds spread their investments broadly within an asset class, owning stocks or bonds of different sized companies in different industries or sectors. Provided the fund isn't too narrowly focused, it may provide you with ready-made diversification.

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What the prospectus can tell you
Mutual funds provide a lot of information that can make it easier to identify and diversify among different subclasses of investments. This is because the fund company has to state in its prospectus how the fund is invested, and what its major holdings are. For instance, if a mutual fund invests primarily in small-cap technology stocks, this will be stated in its prospectus. This means you have some sense of what major asset classes and subclasses the fund invests in, such as small-, medium-, and large-cap stocks, short- and long-term government and corporate bonds, international stocks and bonds, and stocks in specific sectors and industries.

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Finding funds that fit
Mutual funds can make your job of diversifying across different asset classes and subclasses easier. But they can't do all the work for you. You still have to look at how the funds you're considering work together and fit into your overall portfolio.

For example, you don't want to confuse the number of funds you own with diversification. If you own six stock mutual funds that all specialize in small-company growth, you're not diversified — even if you're pleased with the results you're getting at the moment.

Similarly, if your large-cap stock mutual fund owns major holdings in the same six blue chip stocks you already own, your portfolio may be too narrowly focused. In this case, a small-company fund would provide greater diversification.

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International diversification
Diversification can be one of your most important tools to help you manage investment risk. As you diversify, your goal is to realize the best possible returns for the level of risk you're willing to take.The more narrowly focused your investments are, the greater the potential for a major loss in a period of falling prices or market turmoil.

For example, consider the performance of two hypothetical portfolios created by RiskMetrics, a software analytics company specializing in risk assessment, for The New York Times. One was a diversified portfolio of stocks and bonds of both developed and emerging economies. The other was a concentrated portfolio of 80% U.S. stocks and 20% European stocks.

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Balancing risk and reward
Diversification reduces risk, but it also precludes the spectacular success that comes from owning one investment that becomes a major home run. The risk associated with going for broke with one investment, or a limited number of investments, is unacceptably high, and the chances of success are unacceptably low. That's what makes diversification a necessary part of an overall strategy.

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