June 30, 1900
Whether you are an old hand at investing, or you’re new to the investment world, you’ve likely heard the term ‘diversification’ somewhere along the way. But what is it, and why does it matter?
What is diversification?
Diversification is a core principle of most long-term investment strategies. At its most basic, diversification is a way of managing risk by spreading out your investments among a variety of investment vehicles or opportunities. So instead of investing in only one company, where your fortunes depend on the success of that particular company, you might seek to invest in a multitude of companies instead in order to spread out the risk. Basically diversification is investor-speak for the old adage, don’t keep all your eggs in one basket.
The goal is not necessarily to boost performance and diversification cannot guarantee higher returns or guarantee against losses. What diversification can do is potentially counterbalance poor performance in one area of your portfolio with better performance in another.
Why is diversification important?
The one constant in the financial markets is change. We have never seen straight lines of performance trends; the markets are constantly shifting up and down, even if only slightly. The need for diversification arises because we never know when those shifts will occur, how long they will last, how big they will be, and in which direction the market with adjust – up or down. None of us have perfect insight into the future and we need to remember that past performance is not an indication of future results.
Diversification allows the opportunity to potentially lessen the volatility of more narrowly focused portfolios. Bonds and equities can help balance each other out: bonds can dampen the risk posed by equities, and equities can help raise the potential return of a bond portfolio.
While volatility is continual, how much attention you pay to it may impact your investment choices. Patterns have shown that some of our basic instincts, such as fear and greed, may override logical thought process and cause us to over-react to market fluctuations. Factors such as media attention, how often you review a portfolio, and personal situations may impact how you feel about the market or your investments and cause you to make decisions that are against your best interests.
One way to counteract our less beneficial instincts is to focus on what we can control, such as the investment process that determines our investment strategy, risk tolerance, asset allocation, and time horizon. Items that remain outside of our immediate control include market outcomes, public policy decisions, and media attention.
The importance of diversification is maintaining a disciplined approach through a variety of market cycles. It’s important to keep recent performance trends in perspective and be wary of looking at a snapshot in time and thinking that encompasses all of the past and predicts the future.
Some risk cannot be managed by diversifying. Every company has some level of undiversifiable risk associated with it that is caused by many of the things you might expect: inflation rates, volatility in exchange rates, political instability, and changes in interest rates. These are risks all investors face.
However, other risks – like business risk and financial risk – tend to be more specific to a particular company, industry, market,, or country, and these risks can be reduced through diversification. The idea is to invest in a variety of assets that will react differently to the same set of events.
Why use broadly diversified mutual funds?
Broadly diversified mutual funds, like the Green Century Funds, offer a relatively simple and cost-effective way for investors to diversify without having to spend a lot of time researching, purchasing, and selling investments individually. Most diversified funds included a wide variety of securities to limit the amount of risk in the fund, and there are three general rules they follow:
- 75% or more of its assets are invested in securities
- No more than 5% of its assets are invested in any one security
- Contains no more than 10% of all shares currently owned by shareholders
Mutual funds allow investors to pool their money with other investors. The mutual fund managers use these combined resources to make investments across a range of securities. One of the advantages for the individual investor is that purchasing shares in a mutual fund allows you to indirectly own many different securities at a fraction of what it would cost you to purchase them directly. In addition, the portfolio managers decide which securities to buy and sell, and when, which means individual investors don’t have to spend time thinking about it. Why not let us do the hard work?
The Green Century Funds is the first family of broadly diversified, responsible, and fossil fuel free funds. If you are interested in learning more about investment opportunities in our no-load mutual funds, take a minute to let us know. We would be happy to send you more materials to review at your leisure. And if you’re ready to get started investing today, you can open an account right online.