By Shannan Denison, CRPC® Financial Advisor
No matter what you are investing for, be it your retirement, a child’s college education plan or even a cash reserve, diversification can be a key component of success. Wikipedia defines “diversification in investing” as, “the process of allocating capital in a way that reduces the exposure to any one particular asset or risk.” A common path toward diversification is to reduce risk or volatility by investing in a variety of assets. Let’s take that definition one step further and say that it is also important to diversify your investments not only among different asset classes but also with different investment products and tax consideration. Here’s what we mean.
Securities as they’re called by the SEC (Securities and Exchange Commission) typically consists of stocks and bonds. Stocks represent a total asset value of a company divided into shares. As the value of the stock is directly related to the profits and health of the company, it is generally more volatile in its growth potential and performance. A bond, on the other hand, is an instrument of indebtedness under which the issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay them interest (the coupon) or to repay the principal at a later date, termed the maturity date. There is generally no guarantee that the issuer will repay the holder.
Instead of purchasing individual stocks and bonds, investors use investment products such as mutual funds, ETFs (Exchange Traded Funds), and Unit Investment Trusts (UITs).
Many investors are also evaluating the inclusion of “Alternative Investments” as an addition to their portfolio. Alternative investments are defined by Investopedia as, “an asset that is not one of the conventional investment types, such as stocks, bonds and cash. Most alternative investment assets are held by institutional investors or accredited, high-net-worth individuals because of the complex nature and limited regulations of the investments. Alternative investments can include private equity, hedge funds, managed futures, real estate, commodities and derivatives contracts.” You will need to discuss these investments with your securities advisor/professional to understand their characteristics and risks.
Many people get their first taste of investing in workplace retirement plans. Often these plans include a list of pre-approved mutual funds. The better, more diversified retirement plans will have different fund companies to choose from as there is no “specific mutual fund family” with all of the best mutual funds. Mutual fund investing on a regular basis either monthly or with your paychecks may be a disciplined way to invest.
Annuities are investments with an insurance component built into them. Annuities are tax-deferred investment vehicles that may be turned into a lifetime income stream once the annuitant decides that he wants to exchange his annuity for a pension like a benefit. Annuities can be fixed, indexed or variable. A fixed annuity generally produces a fixed interest rate with little to no upside potential. It is also an investment that won’t lose value when the stock market goes down. Index annuities also offer the benefit of not declining in a down market but can also earn more in an up market because its performance is tied to an index such as the S&P 500. Variable annuities have the widest range of investment options but can also fluctuate with
Unit Investment Trusts (UITs) consist of a basket of securities held for a specific amount of time, typically between 18-24 months. These are also generally low in cost and come in a variety of different asset allocation strategies and sectors.
Exchange Traded Funds (ETFs) trade throughout the day like stocks but because most track a particular index there operating expenses are generally lower than mutual funds.
The next time you review your investments be sure to check for diversification not only in terms of asset class but product mix as well.
Your risk tolerance will determine the right mix in terms of percentages.
A financial advisor will be able to review your portfolio and discuss developing a diversified investment strategy.