We’ve boiled down our investing philosophy into two basic principles:
- Invest regularly
- Diversify and think long-term
These principles are part of our larger financial wellness framework called the Stash Way.
Now we want to take a deep dive into diversification, to give you a better handle of this key investing strategy.
Remember we said that when you diversify, you’re not putting all of your eggs in one basket? Let’s really dig in and find out what that means.
What’s diversification, anyway?
We’ve said it before, but we’ll say it again: If you buy only technology stocks or stocks in the defense sector, you’d be putting all of your eggs in one basket.
If tech stocks experience trouble, or the energy industry suddenly must deal with a natural disaster, it’s likely the stocks in those industries will decline together, and you could lose more money than if you were diversified.
A diversified portfolio might have stocks in technology and defense, but it also might include consumer staples, energy stocks, and possibly commodities, such as metals, to name just a few possibilities. (It’s also likely to include bonds and some cash.)
But you can also diversify by balancing your portfolio between domestic and international stocks.
Think of it this way: if you only invest in domestic stocks, you’d be limiting yourself to one economy. While stock markets across the globe experienced losses during the financial crisis that began in 2008, it’s often the case that recessions across the globe don’t happen simultaneously.
By also investing in international stocks, you can potentially spread your risk by putting money into economies outside the U.S., which might perform better when the U.S. is having a bad year or years.
It’s important to note that while diversification is a potentially useful investment strategy, all investing carries risks. In the case of the 2008 financial crisis, for example, diversification may not have protected investors from sharp market decreases. It’s also possible to over-diversify, which means putting your money into too many categories.
Let’s define some terms:
A sector is a large portion of the economy, such as energy, health care, and communication services. These sectors are further broken down into industries, which are essentially made up of the individual companies that contribute to the sector.
Health care, for example, includes companies that manufacture pharmaceuticals, and companies that make the various medical equipment at doctors’ offices and hospitals.
You can diversify your portfolio by choosing among the various sectors and industries in the U.S.
You can also diversify by going global.
International stocks are stocks outside the U.S., divided between developed and emerging markets. (These stocks, generally, will also be broken down into sectors similar to the way domestic stocks are.)
There are roughly 30 developed nations in the world. In addition to the U.S., these include the Western European countries such as the United Kingdom, France, and Germany. In Asia, Japan is considered an advanced economy. And in North America, Canada is also considered a developed nation.
Developed nations have some of the most advanced factories and manufacturing processes in the world. They also have more built out infrastructure, from airports to railways and highways. Access to new forms of infrastructure–like the Internet–may also be higher.
One of the biggest differences between a developed nation and an emerging economy is what people earn, sometimes referred to as per capita income. In the U.S., for example, the average annual per capita income is $56,000. In India, annual per capita income is only about $2,000. Consequently, developed economies tend to consume more products and services.
There are also about 30 emerging market economies primarily in Africa, Eastern Europe, and Asia. Some of the largest emerging nations are referred to as the BRIC nations of Brazil, Russia, India, and China. But there are as many as two dozen others, including Malaysia, Mexico, South Africa, Taiwan, Turkey, and Vietnam.
(China is something of a paradox. It’s the world’s second largest economy, but it’s also considered a developing nation.)
Generally speaking, these countries are less affluent, and the standard of living tends to be lower. Literacy may not be as high as in developed countries, and there also can be less political and economic stability. The currency of these countries can also be subject to dramatic swings, which can affect investments.
Manufacturing tends to be less advanced, and it tends to focus on components that find their way into finished products made elsewhere. Many of these countries also supply natural resources that are necessary in manufacturing, such as petroleum, wood and non-precious metal.
Investing in developed vs. emerging markets
If you think about it, your investments may be safer in industrialized countries with developed economies. But growth potential for companies in these countries may be smaller.
The emerging market potential for growth is pretty big, because these economies are young. Some estimates say emerging markets could grow twice as quickly as developed economies in the next few years.
Diversification and the Stash Way
By now you probably get the picture. When you think about constructing your portfolio, do your research and consider choosing not only domestic stocks, but some international stocks that include developed and emerging markets.