A tip every investor or financial planner will eventually tell you is that you need to diversify your portfolio. Diversification is simply the idea that you don’t want to put all your eggs in one basket, with money. By diversifying your cash into a variety of investments, there’s less at stake if something goes wrong and crashes.
What Does a Diversified Portfolio Look Like?
A portfolio with a good mix always contains a number of financial “ingredients”. Having a combination of bonds, high-yield savings, CDs, U.S. stocks, and international stocks is an example of a portfolio with a large mix of investment vehicles. Source: fidelity
There’s a lot to analyze in the graphs above, so let’s focus on only the U.S. stock and bond percentages for now. If we start with the conservative a portfolio on the left, we notice we have a disproportionately larger percentage of bonds. As we progress towards more aggressive portfolios on the right we notice that the proportion of U.S. stocks drop.
The 120-Age Rule
When you’re first starting to diversify your portfolio a good rule of thumb to follow is the 120-age rule (This was formerly known as the 100-age rule. The 120 rule is starting to gain traction since Americans are living longer and retiring later).
Let’s say we are 30 years old and beginning to put funds into our first portfolio. With the 120-rule our proportion would be somewhere around 90% stocks with 10% bonds, a very aggressive portfolio! On the flip side, a 60 years old investors portfolio would sit around 60% stocks and 40% bonds. A portfolio with this sort of ratio would be considered conservative.
You may have noticed that there’s a certain reasoning behind the 120-age rule. Younger investors will have more stocks that are gradually swapped with bonds as they grow older. Stocks are considered higher risk relative to bonds because they are more volatile. Their value is dependent on a number of factors, difficult to consistently predict, but have higher returns. Bonds are more stable form of investment since they are usually government issued or backed by a major corporation, but have lower returns that have trouble beating typical market inflation.
Younger investors are able to take on more risk because they have a higher risk tolerance. Market swings and sudden loss of financial wealth of 50% or more hurts less when you still have a steady stream of income (but it still hurts!) Losing half of your wealth in retirement, where you no longer have a stream of income is devastating. Older investors thus have a lower risk tolerance, since there is more at stake if things go awry.
There’s a great video by Investopedia that covers the differences between stocks and bonds. It’s important to have a mix of both investment vehicles in any portfolio. As with many financial investments, there pros and cons to both that often complement and balance each other out.
Optimizing Your Portfolio
Diversifying your portfolio works wonders because not all the action happens in one place. Here we covered covered two of the most common investment options to understand the subtle differences between each other. Part 2 covers other ways portfolio start to vary such as different sized companies, domestic/foreign stocks, savings accounts, CD’s, and bonds. They’re all tools with their own purpose once we hit certain money milestones. Congratulations to those who have covered all these bases and can consider their portfolios well-rounded.
Per usual, thanks for taking the time to read BrunchBucks. If you find a typo just contact me via email! Feel free to leave a comment below or share this with friends.
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