Sept. 15, 2022, 4:57 p.m. EDT

This is the first rule to follow if you’re getting started investing in stocks

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By Brian J. O'Connor

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If you’re thinking of putting your money to work, you have likely heard about the importance of portfolio diversity. But why does it matter? 

Maintaining a well-diversified portfolio is one way to reduce risk and losses in your investments while also simplifying your decision-making process. It’s rare for one type of stock – such as blue chips – to be the best performer for more than one year in a row. For example, tech stocks may be big gainers one year but take a big fall the next year, only to see international stocks or some other sector record big gains. Diversification means you’re more likely to nab the winner and even out your investment returns. 

When you’re getting started investing in stocks, the first rule is to keep it simple: Buy an inexpensive mutual fund or, better yet, an exchange-traded fund (ETF) that captures the broader stock market. These are funds that mimic indexes such as the Standard & Poor’s 500, an index that follows the 500 largest companies traded on U.S. stock exchanges.

There’s also the Wilshire 5000, a similar index that contains about 3,500 companies  and is designed to reflect the total market of publicly traded companies on U.S. stock exchanges. (Yes, 3,500 is less than 5,000 companies — but the index was created in 1974 and, hoo-boy, have things changed since then). 

For most young investors, diversifying means creating a portfolio that includes more stocks than bonds, while investors older than 40 are typically advised to add more bonds. The thinking here is that younger investors have a long time to go before they’ll need to start selling their investments for retirement income, which means they have many years to ride out the ups and downs of a volatile market. While there is more risk involved when a larger share of your portfolio is invested in stocks, there is potential for greater returns. 

Older investors need to start lowering their risk as they get close to retirement because they have less time to recover from a market downturn. Typically, this is done by gradually moving into bonds or other more stable investments as the investor approaches retirement age. A financial adviser can help you figure out exactly when to start shifting your holdings.

Whatever your investment objective, the amount of risk and diversity in your account needs to be based on your time horizon. That is, the amount of time until you need the money you’re investing. If you’re investing to buy a house in five years, you need to be conservative and stick with a lower-risk investment approach. You may not earn a huge return, but you also won’t risk the entire down payment for your dream home. Likewise, parents saving for a child’s college education can be moderately aggressive when the baby is toddling around the house but should have sold most stocks by the time the kid graduates high school. 

The point of diversification is to find investments where the loss from one security doesn’t correlate to another. While stocks rise and fall with the fortunes of the company behind the shares, bonds pay a fixed rate of return during their lifetime. So, if the S&P 500 falls by 30%, a 10-year Treasury bond paying 3% interest isn’t affected. In fact, the bond could be sold at a profit because bonds become more attractive to investors when stocks fall. The resulting stability eases your portfolio’s losses even though it clips your returns a bit. But here’s the key: Over the long term, limiting losses results in a better payoff even when it means forgoing some gains. 

Let’s do the math: 

  • You are 100% invested in the total stock market when stocks lose 50% of their value, dropping from $1,000 to $500

  • If you gain 50% you’ll be back to even, right? No — your stocks still are down by 25%, at a value of $750. 

  • To get back to your starting point, your stocks now need to double, from $500 to $1,000, or by an increase of 100%. 

Now let’s try with smaller losses:

  • You are invested in a mix of stocks that are more stable, including some in sectors that produce income, some with share prices that are less volatile, and some in real estate or commodities such as gold. When the stock market falls  your diversified portfolio drops by 20%. 

  • To get back to even you need your total portfolio to gain just 25%. On top of that, your investments that didn’t lose money are now more attractive and likely to be gaining in value as investors bail on the shares that took a big hit. 

  • At that point, when the total market gains back just a fraction of its losses, your investments already are back at even and ready to keep growing as the market recovers.

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