By Peter Eickelberg, CFA®, CFP®
Concentration, diversification, and “diworsification” are terms that are often discussed in the world of investing. Understanding these concepts can help you make informed investment decisions to mitigate your risk while creating a well-rounded portfolio that performs as intended. Today let’s dive into the meaning of these terms and explore three ways to expand your portfolio to help position your assets for an informed risk/return tradeoff.
What’s the Difference?
At its core, diversification just means not putting all your eggs in one basket. It can refer to buying more than the stock of one company, more than just one bond, more than just one piece of real estate.
When implemented properly, diversification can greatly reduce the impact of one company’s performance on your stock portfolio, since the risk is spread out among different investment options. It can also offer additional sources of investment returns. For instance, different countries’ bond markets may provide varying interest rates. By accepting the currency risk of another country, you can increase interest income by investing both domestically and internationally.
Concentration is the opposite of diversification and can be a good way to make or lose a lot of money in a short period of time. It has been said, “Fortunes are made by being highly concentrated; fortunes are preserved by being highly diversified.” We’re all for investing in your small business to grow your wealth, but there comes a time when you want to protect what you’ve achieved.
Diversifying across various types of assets can be a helpful default strategy because this keeps something in your portfolio always performing well on a relative basis. However, it also means there may be assets that are not performing as well.
This begs the question: Does diversification have its limits? Warren Buffet has been known to criticize excessive diversification as “diworsification” because not all investments yield positive results. By investing in assets outside of the top performers, returns can be lowered. It’s important to consider that relying heavily on a specific industry’s recent performance can be risky, as demonstrated by the dot-com bubble in 2000.
In spite of these differences, as an investor it serves you best to consider diversification as a tool to reduce risk while maintaining a steady increase in returns. As you consider what to add to your portfolio, consider three options to help round out your financial strategy.
1. Real Estate Investment Trusts (REITs)
Real estate is a great way to diversify your portfolio, but few people have the resources to invest in large-scale commercial real estate directly. That’s where real estate investment trusts (REITs) come in. Instead of owning property outright, REITs allow you to own shares in a portfolio of properties. You get all the benefits of real estate ownership—such as stable, passive income—but without the headaches of directly managing a property. You also may benefit from active management both in the REIT itself and at the portfolio level (i.e., in a REIT fund)
Pros
- More liquid than directly owning real estate.
- Provides passive income.
- Diversification can mean less risk.
Cons
- You don’t have a say over how the properties are managed.
- REITs are publicly traded, so their value fluctuates with the stock market.
2. Alternative Exchange-Traded Funds (ETFs)
An exchange-traded fund is a collection of securities that trade like a single stock—and those securities can include anything from normal investments like stocks and bonds to alternative options like precious metals, energy, agriculture, and other commodities.
Alternative ETFs, like precious metals, have historically often moved in ways not directly linkedto that of stocks, which can help moderate the ups and downs of your portfolio. For example, when the stock market takes a turn for the worse, precious metals may rally and thus soften the blow.
Pros
- More liquid than investing in the assets outright.
- Investing in an alternative ETF means automatic diversification.
- Buying and selling an ETF is as easy as trading stock.
- ETFs are passively managed, so they have lower expense ratios than actively managed funds.
Cons
- Not all ETFs are created equal, and some are riskier than others.
- Fees for alternative ETFs tend to be higher than for stock ETFs.
3. Annuities
Annuities are a type of insurance product that offer a guaranteed stream of income for a set period of time. They’re a popular way to fund retirement and—when used correctly—provide financial stability when you need it most. Annuities come in countless varieties, so it’s important to get help from a financial professional when selecting the best product for your needs.
Pros
- Generate a steady income for life, so you never have to worry about outliving your money.
- Often earn a guaranteed rate of return, so you don’t have to deal with stock market fluctuations.
- Distributions are deferred, so you don’t pay taxes until you withdraw funds.
Cons
- There are hundreds of annuity options, which makes it hard to know which ones are the best fit for your needs.
- Annuity earnings are taxed as ordinary income instead of capital gains, so you’ll likely pay a higher tax rate on gains.
- Many annuities are sold through agents who earn a commission, so there are often hefty fees involved.
Partner With a Professional You Trust
When it comes to different types of investments, it’s important to consider their unique advantages and disadvantages in relation to your long-term goals and financial plan. At ABLE Financial Group, our mission is to support individuals like you in growing and shielding your wealth for future generations.
Through goals-based investing, we prioritize diversifying your portfolio. And fulfilling our fiduciary duty to put you first, our team’s process helps you feel confident that when we make financial decisions on your behalf, they are always consistent with the goals you’ve outlined, helping deliver outcomes that are important to you. To learn more about our team and the ways we can help guide you, call 480.258.6108 or email peter@ablefinancialgroup.com today.
About Peter
Peter Eickelberg is a Portfolio Manager at ABLE Financial Group, a financial services practice that focuses on transition planning and simplifying the complexities of their clients’ wealth.
Peter brings more than 20 years of experience as well as broad formal training across many aspects of financial services, including investment types and strategies, investment planning, private equity, compliance, and investment committee best practices. He has been a CFA charterholder since 2004.
He has served clients locally as a registered representative with a major discount brokerage and as an independent registered investment advisor with two independent registered investment advisors in the Valley. His past roles have included Chief Compliance Officer and Senior Investment Officer. The latter position involved a major US-Canada wealth management firm, where he oversaw all investment operations and strategy decisions. Peter also served on the board of directors for the CFA Society of Phoenix and was president from 2008 to 2009.
What may come as a surprise is that Peter didn’t study finance in school and didn’t even know what a mutual fund was until 1998. Instead, he has two degrees in English and was briefly a teacher both in the US and overseas. He maintains his interest in languages and international travel, though, and hopes to continue enhancing his language skills and cultural experiences outside of work.
Peter is a Phoenix native (yes, they do exist!), having spent most of his life in the Biltmore area. He lives on an oversized, flood-irrigated lot where he grows around 15 different kinds of fruit-bearing trees and bushes and also cultivates vegetable and herb gardens as well as decorative plants. When he can find time and focus, he enjoys practicing guitar and piano.
