Investment analysts often suggest that investors diversify their investment portfolios. This entails buying a variety of different types of securities rather than investing in one type of security or even one specific stock or bond. Many people view diversifying a portfolio as a defensive move that protects your money in the event that one security drops in value, but it often minimizes your potential returns. If you have a conservative investment selection, you could potentially increase your returns by diversifying your portfolio.
Conservative Versus Aggressive
You can buy a variety of different securities for your portfolio, including stocks, real estate holdings, bonds and insurance contracts. Stocks offer you the best chance of growth, as stocks have no principal guarantees but rise in value in line with the performance of the company that issued the stock. In theory, stocks have unlimited growth potential. Bonds are less volatile than stocks but provide steady income, and you get your original investment back when the bond reaches maturity. If you diversify your portfolio by adding more stocks, you adopt an aggressive investment strategy and have more chance for higher returns or steeper losses. If you diversify by adding more bonds or real estate contracts, you limit your growth potential, but also help cushion losses.
Stocks can lose value based on the performance of a company but also based on supply and demand. A stock could plummet in value due to large numbers of investors selling their stocks at the same time; while stocks offer the chance for higher returns, you could literally lose most of your investment in a single day. If a company goes bankrupt, the claims of bondholders are settled before stockholders can make claims on the company's assets, so bonds are less risky. However, you can still lose money as a bondholder if the bond issuer goes bankrupt, so bonds are not 100 percent safe investments.
When you view your investment returns, you often find that your net returns are much less than the gross returns due to fees being assessed by investment firms. The more you diversify, the more fees you typically pay to different investment firms for buying different kinds of securities. More trading activity means more trading fees. Therefore, you may see your net returns reduced as a result of selling some of your holdings and purchasing a number of different securities. You can reduce the impact of fees on your portfolio's returns by buying a mutual fund that invests in a diverse range of securities rather than buying multiple different securities yourself.
Taxes also affect your investment returns. If you diversify by buying short-term investments such as securities that mature within 12 months, you pay ordinary income tax on those short-term gains. If you hold securities for more than 12 months, you pay long-term capital gains. For most people the ordinary income tax rate amounts to more than the capital gains rate. Additionally, most types of municipal bonds pay tax-free income, which means you can add to or reduce your tax liability by adding or removing these bonds from your portfolio. The tax consequences of diversifying your portfolio can therefore greatly impact your returns.