Some things to think about before giving your portfolio the stamp of approval.
You've no doubt at some point in your life stumbled upon the term diversification (the financial variety). When it comes to investments, proper diversification across multiple companies, sectors, and macro-level economies is a great way to maximize yield while minimizing risk. When for any given investment the odds are generally in your favor, one way to 'lock in' those odds is to increase the number of investments by dividing your assets into small, individual pieces (for more detailed information about how this works, read up on the Central Limit Theorem).
Diversification is an established tenet of conservative investment. -Benjamin Graham
Think of it this way: imagine you are setting up a casino. You theorize that if you create odds that are drastically against your patrons, they will eventually pick up on this fact and never return to play your games. On the other hand, if you make the odds of winning too advantageous for your customers you will go broke rather quickly. Thus you set the odds in your favor, but only slightly... say 60% chance of the house winning any game.
Given these odds and the fact that you have a casino business to run with employees and bills to pay, would you prefer 1 patron to place a single bet for $1,000,000 or would you prefer 1,000,000 patrons placing individual bets for $1? Considering the Central Limit Theorem (and maybe a little common sense), the answer is simple: we want many small individual bets for an all but guaranteed overall return. One large bet is simply too risky and too unpredictable. Thus we should strive to set up our own finances in this same way.
The Good News
For the most part, its relatively simple to ensure your retirement and brokerage accounts are diversified. Pre-diversified mutual funds and ETFs are great ways to help with this. All one needs to do is make sure they have a good mix of stocks in different sectors across the US and internationally. This can be accomplished with just 3 or 4 funds. Note: I'm aware a single target date 20XX retirement fund can give excellent diversification by itself, but I am excluding them from consideration here because I have a beef with them... perhaps a topic for another time.
Common Mistakes
You may be a whole lot less diversified than you realize, even if your stocks are allocated to perfection. When you look at all of your assets combined, how much of your net worth is tied up in specific investment types?
Do you own a home? That's hundreds of thousands of dollars tied up in the real estate sector. But it's actually worse than that. It's real estate in a single country in a very specific zip code on a very specific street. There isn't anything you can do to fix this, but personal diversification should be a consideration when purchasing a home.
Does your company match your 401k contributions with company stock? You could be holding a substantial amount of stock in a single company. And not just any company, but the very same company you depend upon to keep you employed. The ideal amount of stock to own in the company you work for is zero shares. It doesn't matter how good you think your company is. The ramifications of your company's performance going south with you working for it are just too risky.
Do you have a substantial amount of money sitting in high yield savings accounts or money market accounts? At first glance this may seem like a risk-free investment... but the fact is that even with this kind of investment you are fully depending on the United States Dollar performing well on the FOREX. Not only that, but this type of investment isn't even close to being optimal on the efficient frontier. In other words, your return is small and you still have risk, whether you like it or not.
As long you are taking steps to consider diversification across all of your assets (not just stocks), you will be more prepared to maximize returns while reducing risk.
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