Sometimes investing is like walking across a frozen farm pond. Interesting, but risky. Which also describes the current stock market with all its volatility. Interesting, but risky.
Larry Burkett described a market environment similar to today’s market in his book Preparing for Retirement. In it, he addressed the impact of inflation on bonds or other fixed-income investments. “An inflationary cycle can easily erode the value of a long-term bond fund since interest rates on long-term bonds are locked in for years at a time. If the current interest rates rise (as they would in an inflationary period), the value of the bond fund declines. At that time, it would be advantageous to be able to switch over to a good stock fund. But in cycles where the market is overvalued, stocks and stock funds can lose much of their equity, so a bond fund can help protect your assets.” (Burkett; Preparing for Retirement)
When the future of the market is uncertain, the need for diversification is strongest. Market risk, interest income risk, and inflation risk can all be mitigated by simply diversifying. Your momma told you never to put all your eggs in one basket. The Bible even gives wisdom about diversifying in Ecclesiastes where it says, “Give portions to seven, yes to eight, for you do not know what disaster may come upon the land.”
Larry Burkett spoke about diversifying a $100,000 investment portfolio. He said, “The one thing you should be able to achieve with more resources is greater diversification. If you will set a limit of say $10,000 per investment (maximum), the risk will then be spread into ten different areas. Even a loss of 50 percent in any one investment would only dilute your assets by 5 percent.” (Burkett; Preparing for Retirement) I agree with his advice but would amend it to say you should limit investments to a 10% weighting in any given investment.
A diversified portfolio will look different for each person, but regardless of how it specifically looks, spreading your money out over a few different investments has its advantages. One example is that it can reduce business segment (such as manufacturing, transportation, real estate, finance, etc.) or geographic volatility. If a person is invested only in real estate, then they will feel the full effect of a downturn in the real estate market. But if they only have 10% of their investments in real estate and there is a downturn, then they only feel the negative effect of the downturn in 10% of their investments. Similarly, if a person was only invested in New Orleans-based companies before Hurricane Katrina, they would have felt a greater than normal negative effect of the hurricane.
I learned this lesson as a child trying to win a bet from my cousin. I bet him that I could cross my Poppy’s frozen pond. Even fat boys from Galena can cross the ice on a frozen pond; the secret is spreading your weight around (Don’t do this at home!). Just like I spread my weight out on that ice so I wouldn’t fall through, it may help to spread out our investments, so our portfolios don’t take a drastic hit. Invest in investments that are in different types of businesses, located in different parts of the country, and are exposed to different kinds of risks.
Have a blessed week!
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial, a registered investment advisor, Member FINRA/SIPC.
There is no guarantee that a diversified portfolio but when hands overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.