Source: Nasdaq via Facebook.
The broad market indexes have been nothing short of unstoppable since hitting their lows in March 2009. The S&P 500, arguably the index that most accurately reflects the overall health of the market, has risen by nearly 220%, while the Dow Jones Industrial Average and the Nasdaq Composite are also regularly hitting new all-time highs.
The stock market has helped to reignite retirement savings accounts for workers in their 20s all the way up to current retirees. However, the Great Recession served as a great reminder for investors to diversify their holdings.
What is diversification? It's the process of deliberately spreading around your money in order to minimize risk. To be clear, diversification strategies do not guarantee that you will profit. No such strategy exists; all investments involve some level of risk. Instead, you're merely using diversification as a means to deleverage your portfolio from higher levels of risk and to potentially limit volatility.
Let's briefly look at three different ways to improve your diversification strategy.
1. Consider index funds or ETFs
You probably saw this one coming, but one of the best ways to diversify while also allow taking advantage of the stock market's historically superior returns is to buy an index fund or an exchange-traded fund, or ETF.
An ETF is nothing more than a basket of stocks held in a single fund. In exchange for a commission to your broker and a nominal annual expense fee, you can own a large group of stocks that represent either the broad stock market or a specific sector.
For example, let's say you want exposure to the high-growth biotechnology sector but can't handle the deep research the sector requires, or you don't have the stomach to ride out the sector's notorious volatility. There's a simple solution to that: the SPDR S&P Biotech ETF (XBI +1.71%).
Source: Food and Drug Administration via Facebook.
The fund currently holds 99 stocks that have an average market value of nearly $9.2 billion (so we're not just talking about speculative coin tosses here) and are expected to grow their earnings over the next three to five years by approximately 40%. The fund's gross expense ratio -- the fee it charges investors for managing the fund -- is just 0.35% annually. But the really good news is that the ETF also has a dividend yield of 0.8%, which more than covers those costs.
Buying the SPDR S&P Biotech ETF won't guarantee a profitable biotech investment. However, if one company in the fund is halved overnight on bad clinical data, you'll lose a very small amount of your investment as opposed to a full 50%.
According to the Investment Company Institute, as of December 2014 there were 1,411 ETFs to choose from, bearing total net assets of close to $2 trillion. In other words, you pretty much have no excuse not to consider an exchange-traded fund in order to diversify your portfolio, as there's practically an ETF for everything these days.
2. Always be investing
The next tip to improve your diversification strategy is what I call the "always be investing" strategy. Some of you might know it better as dollar-cost averaging, but I'm a firm believer that you can average into a stock on the way up just as easily as on the way down.
Source: Pictures of Money via Flickr.
The idea here is simple: Timing the market is a fruitless task that rarely results in replicable successes over a long period of time. However, over extended time frames, the stock market has also demonstrated substantial gains of about 8% per year. If you focus on buying for the long term and holding on to your investments, you should end up with at least a few big winners over the long run.
When to invest is a question that haunts many investors -- and the best answer is "always." Set aside a fixed amount of money on a regular basis -- each week, two weeks, month, quarter, etc. -- and invest it in the stocks you already own, or in new companies, regardless of how the market and your individual investments are performing. Trying to pinch pennies by waiting for the best buy-in price can cost you a significant amount of money in the long term, as no investor can consistently buy and sell at the best times. By spreading your money out over a longer time frame, you have a better chance of taking advantage of the markets' gains and minimizing the negative effects of short-term bear markets.
3. Try different types of investments
Finally, investors can improve their diversification strategy by spreading their wealth among different types of investments.
Source: Flickr user Sara Hughes.
One thing to remember is that although certain investment vehicles are safer than others, it's never wise to throw all of your money in a single type of investment. For example, even though the stock market has historically outperformed all other types of investments over the long run, a pre-retiree or retiree who simply catches some bad luck could find their nest egg hammered by a recession. Conversely, buying a U.S. Treasury bond will practically guarantee an investor a nominal profit, but it will also likely cost them money in real terms, given that inflation levels are higher than the yield on most Treasury bonds.
In other words, your best approach is to balance your investments based on your investment goals, your age, and your risk tolerance. Investments to consider include government and corporate bonds, mutual funds, ETFs and individual stocks, and bank CDs. Weighing your investment goals will determine whether some or all of these investment tools are right for you.
If done properly, diversification can protect and enhance your nest egg.
