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The Keys to a Well-Diversified Portfolio

So, let’s say you have taken the first big step in your investing career, you have either started up your first trading account, or invested in your first rental property, or maybe you have even gotten into cryptocurrency. 

That is fantastic, the hardest part of starting is getting everything set up and getting money into your accounts.  The second hardest part is figuring out your strategy moving forward.  Keep reading and I’ll share my ideas on what is in a well-diversified portfolio, which should be everyone’s end goal.

At this point in time, cash is truly the least valuable asset you can have in your portfolio.  You certainly need to have access to some quick cash in case you run into a situation.  Say your furnace goes out in your home, your transmission goes out in your car, or work is slow, and they asked you to not come in for a week.  However, the days of sitting on $30,000 grand in a savings account are over. 

There are two main points I’m trying to make here.  Number one, if you have any type of “extra” cash laying around, find something to invest it in.  Extra cash means it’s just money that would maybe be going toward your nest egg. 

Number two, once you get established and are consistently setting aside money to invest, make sure you start thinking about how you want to spend that money.  It’s easy to buy every stock you see on the news, but hitting that easy button isn’t always the answer.

As with anything that has a risk, there are certain things you can do to enhance your chances of success and things you can do to ultimately lead you to failure.  Making sure you have a well-diversified portfolio, even when just beginning your investing career, is extremely beneficial.   Below are a few tricks of what a well-diversified portfolio looks like.  Remember, it doesn’t matter if you have $1,000 invested or $100,000, diversification is important to everyone.

How Diversification Works

Think about it this way, if you went to the grocery store and knew you weren’t going back for one month, would you buy all the same food?  Heck no, you may have a favorite that you buy a larger quantity of, but you are going to buy some different things, so you don’t get bored with the same food day in and day out.

The same is true with investing, you want to try some different things to limit your risk.  Let’s say you have $1,000 you want to start investing with, would I recommend investing it all into bitcoin right off the bat?  Not at all, that is putting all your eggs in one basket, and a risky basket at that.

There is nothing wrong with investing in a cryptocurrency, but you must understand that it comes with a certain amount of risk.  In a well-diversified portfolio, I would recommend keeping these “risky” investments closer to 10 or 15 percent of the total portfolio.

What do I consider risky?  At this point, any type of cryptocurrency is a huge short-term risk in my opinion.  In the long run, they have slightly less risk, but I’m not in a position where I’m ready to say crypto is a low-risk investment. 

Other risky investments could be purchasing stock of a brand-new company or buying a rental property sight unseen.  The bottom line here, keep high-risk investments to a minimum of 15 percent of your total portfolio.  These are investments that could double or triple or go to zero.  It’s fun to have them, but it can’t be everything you own.

On one side it’s important to minimize high-risk investments in a well-diversified portfolio, but you must also make sure to have a small percentage of what I call “no brainer” investments in a well-diversified portfolio.  These types of investments may only provide five to six percent return annually, but it’s nearly a guarantee that your money will do the work for you, and it’s certainly a better return than interest in a savings account.

What would I consider the best no-brainer investments to diversify some safety in your portfolio?  Number one, purchasing high dividend stocks.  These are usually shares that can remain flat to slightly up or down in value in the short-term, but they are paying anywhere from five to six percent dividend annually.

A good example of a high dividend stock in action is Exxon Mobil Corp (XOM).  You could start by purchasing five shares of XOM for roughly $320 plus any fees you may occur.  At the end of the year, your dividend will be right around $17.40 (depending on share fluctuation) or nearly a 5.5 percent return on the dividend alone. 

Remember, the stock could lose money for the year, and you still net a profit of the dividend.  Even if the XOM share price dropped by $3 over the course of a year, you are still ahead in this scenario.

Here is another real-life example I just went through recently.  My parents have owned a house for years and rented it out to the same family.  They have legitimately had the same renter for 20 years, which must be some sort of record. 

Then last month, my father asked if I wanted to purchase the home and continue renting it out for a bit of additional income each month.  Sounds easy right?  There are a lot of things to think about in this situation.  So, I went through a full analysis to figure out if this investment was low or high risk, and to see if it was the right fit for a well-diversified portfolio.  See breakdown below.

Evaluating the Risk and Return of an Investment

Let’s just keep numbers simple for time’s sake, but I want to run down the exact math I had to do in order to evaluate the return and risk of the investment.

1 – Evaluate the Mortgage Payment

This investment would require me to take out a $150,000 mortgage to buy the house.  That cost me $30,000 of cash for a down payment and three percent on interest for a 15-year mortgage.  That means I’m taking $30K out of my current investments that were at least making a 10 percent return and paying an additional $39,769.74 of interest during the life of the loan.

2 – Evaluate the Costs: 

The 15-year mortgage was going to cost me $850/month.  That included taxes, interest, and insurance.  The renter would be responsible for all utilities in the house.  There is always a risk of unexpected costs for maintenance and repairs, but I was confident the house was in pristine condition.

3 – Evaluate the Return: 

My parents had rented out this house for years for $1,150 per month.  Meaning I would be bringing in exactly $300 per month profit, $3,600 per year, or $54,000 over the life of the 15-year loan.

Simple math tells you that the $30K out of my pocket and nearly $40K of interest doesn’t hurdle the $54,000 of profit over 15 years.  But remember, there are a few more items you may not be thinking about.

1 – Inflation

While my mortgage is fixed, the cost of living will continue to go up.  At a $300 per month profit, I’m thrilled if I can keep the same great renters for another 15 years.  However, I know if they ever move out, there is a good chance I could raise the rent at least $200 per month which increases my profit substantially.

2 – Extra Payment

With investment properties, you always must plan on something breaking.  It’s just the nature of the beast, unfortunately.  However, until that happens, I decided to add half of my $300 profit a month to the principal amount and take nearly $10,000 of interest off the loan.  The good news about an extra payment, you can pay it if things are going well, and you can always take it away if you need the extra money to pay for repairs.

For example – a month when the hot water heater went out, I took the additional $150 of paying off the mortgage to help pay for the expenses.

3 – Principal Value

We certainly can’t forget that the asset you own has value as well.  If I purchased the house for $150,000 in 2021, it may be worth that or even more in 15 years and I’ve had the mortgage paid for the entire time.

Long story short – If I never raise the price of rent over a 15-year period I’ll make $207,000 off rent.  During that same time, I’ll have made $153,000 in payments. That leaves me more than $50,000 of room for repairs, and I’ll still have an asset I can sell for a large chunk of money.

I will admit, this scenario is different than most.  I know the complete history of the house, they already have great renters on the property, and it just so happened I had the cash to be able to make the purchase.  At the end of my evaluation, I established this was another safe risk to add to in a well-diversified portfolio. 

My goal will be to break even or slightly better on the investment over 15-years and then be prepared to sell it when my children are getting ready to start college. 

Now that we have touched base on limiting the risk in your portfolio and making sure to keep a small percent of safe investments in a well-diversified portfolio, what other strategies should a new or any type of investor follow?

Diversifying the Timing of Your Investing

One thing I wish I would have done differently when starting my portfolio; buying in gradually.  What I mean by this is, if you have $5,000 you are interested in investing, don’t buy $5,000 worth of stock all on the exact same day. 

Don’t get me wrong, you may time the market perfectly and buy everything on a low day, but you also may be buying everything at a huge blip in the market.  It’s natural to want to buy stocks when the market is rising, and you get the itch to sell everything when it’s crashing.

Logically, you should be doing the exact opposite of that.  That’s why buying in slowly over time and continuing to make small purchases spreads out your risk.  This strategy will help you ride out the peaks and valleys of the market, which will without certainty occur.

My recommendation would be, spend 10% of your total commitment in week one.  Watch it for a week and see if you can really start to understand the investments you made.  Then each week continue to throw in 10 to 15 percent of your money until you have hit the limit on what you want to spend.  Over this period, you should get a much better understanding of what will do well, and what may underperform from your original expectations.

You can’t convince me you’ve never made a mistake in life from acting too quickly, this strategy just helps eliminate the excitement factor of purchasing stocks.

Dollar Cost Averaging

The next strategy can be difficult to follow but is the best way to keep yourself active in your portfolio.  That is continuing to make small purchases or investments every single month.  What I did to accomplish this was a direct deposit every third Friday of the month to my E*TRADE account.  It’s not much, only $50, but this keeps me on the hunt for new stocks to buy.

Not only does this keep me hunting for new stocks, it also forces me to watch them for a month or two before I build up enough capital to buy multiple shares.  There are sometimes when I wish I would have just bought it right away, but also times when this helped me learn that it was wise to wait, and I didn’t end up purchasing. 

The last point on what’s in a well-diversified portfolio may be the hardest one to manage.  While it’s great to have high and low-risk investments and have a deep portfolio that you are constantly adding to, you must also figure out if there is ever a time to just get out of an investment.

Sometimes the mentality of stocks is to just buy and hold them.  That is truthfully a sound strategy, but if you really want to diversify your portfolio and enhance your chances for success, you need to constantly be watching market conditions to see if it ever makes sense to exit a market.  That means you may see a lot of trades in a well-diversified portfolio, which goes against what some people may tell you.

Timing the Market

Buy and hold is, by all means, the safest strategy in owning stocks, and as a new investor, it will always be the strategy I recommend.  There is money to be made by jumping in and out of stocks and “day trading”, but any activity like that would need to be labeled high-risk.

But that doesn’t mean you can’t do your homework and still better your chances at creating a well-diversified portfolio.  Constantly readying publications and following stock tickers should only improve your ability to time the market or buy when the stock may be at a bit of a dip.

Look at this history of a stock like Netflix or Tesla that constantly has big dives down, and huge lifts upward.  I would challenge everyone to read at least two to three pieces of literature a week to keep a grasp of where the companies are that you have invested in.  Quarterly earnings reports for each of these companies are a tremendous tool. 

There are multiple examples in each stock I mentioned where you may have been able to read the company was missing targets, sold while making a profit, and then bought back in months later at a much lower value.

Other signs to watch for on getting in or out of the market, is inflation going through the roof, are interest rates increasing, what does the job report looks like.  Truthfully, all things are starting to show some red flags at this very moment.  The Dow has remained at all-time highs the last 10 months, but there are more and more signs that a collapse (that sounds a bit harsh) could be coming sooner than later.

The big takeaway from this, investing is like a garden.  You don’t just throw money at something and expect great things.  You must water it, weed it, and hope for some sunshine for it to really blossom.  It’s easy to buy a few stocks and put things on autopilot.  To truly be successful it’s important to do your homework on each investment, look for investments outside of the stock market, and before you know it, you’ll find yourself with a well-diversified portfolio.