We have all heard the saying, “Don’t put all your eggs in one basket” when it comes to how you should be invested, but what does that really mean? Some people think that having accounts with different companies or investing in different mutual funds will effectively diversify their investments. While doing that might work, it is hard to get a grasp on how diversified that makes you unless you know exactly what you are truly invested in.
If you have accounts at several different firms, are you communicating to make sure each account is not creating redundancy by buying the same stocks and fixed income investments? Do you own different mutual funds only to have the funds own the exact same stocks? Do you have too much of your money invested in one area of the economy such as technology or healthcare? How would you be able to find all that out?
The first step is to achieve transparency within your accounts. By seeing what you own and having it laid out in a way that makes it easy to understand is a good first step. There are companies that offer services for reporting within the investment industry. The value add that these companies bring is to show asset allocation, diversification or lack thereof and performance. These companies have developed reports to help advisors present to their clients account information in a way that makes it clearer to understand than traditional brokerage firms.
So now that transparency is better how, do you know if you are properly diversified? There are several questions that can help you get the answers you are looking for. The first and most important step is to figure out what types of assets are available for investment. There is the stock market, which is the best historical return but also carries greater risk than other types of investment. Fixed income investments carry less risk, but also less return. Types of fixed income investments might be corporate bonds, municipal and government bonds, and certificates of deposit. There is also real estate, which many people like to invest in personally, but there are ways to invest in the real estate market without having to buy physical property. Today we will focus on stocks.
Stocks are always fun to talk about when the market is going up and can cause fear and loathing when the market is down. So how do we buy stocks and cut down on the risk that comes with them? To understand that, we must understand the risks we are taking when we purchase them. There is, of course, market risk which is the up and down movements of the market over time. While the movement can at times be volatile, for someone who is patient and stays the course, the returns are second to none. The other risk is business risk, also known as specific or diversifiable risk. This is the risk involved in buying too much of one company. If someone invests in the stock market, it is impossible to diversify out of market risk, but if done properly, one can invest in stocks in a way that almost completely eliminates business risk.
The world economy is almost completely represented within the stock market. If someone invests in all areas of the stock market without becoming too heavily invested in one area, they can reduce their business risk down to a level that is almost undetectable.
Looking at the figure below provided by Ibboston, we can see that risk is represented on the left side of the graph and along the bottom the amount of stocks owned. If you look closely, you can see that somewhere between 30 and 50 stocks the business risk almost disappears. One thing to keep in mind is that investing in all areas or sectors of the economy also helps stabilize the volatility that can sometimes be encountered by becoming too sector focused within the economy.
In summary, it is important to understand how much of your money is invested in stocks, bonds and real estate, and how your money is allocated across those classes of investments. Looking deeper into stocks, we must make sure the stocks owned are spread across all sectors of the economy and not over weighted in any one area.
If you would like to make sure that the risk in your investments is not more than what you think it is, please feel free to contact us at Davis Capital Management (904-223-0510) or visit our website at www.DavisCapitalSite.com .