When I was a kid in the 1990s, I wanted a pair of Air Jordan sneakers. During Michael Jordan's playing years, every time Nike came out with a new Air Jordan sneaker, it was a big event. But even though my dad could afford to buy me a pair, he thought the shoes were overpriced and said no. I felt scarred for life.
When I got older and had money of my own, I started buying my own Jordan sneakers. Today these iconic shoes have ballooned into a collectibles marketplace, popularized by social media, YouTube videos, resale sites, and even conventions and trade shows. Listening to a sneakerhead talk may sound like a foreign language, with slang like: "AJ1, collabs, on ice, retro, OG."
Just like the lingo of the sneaker world, the language of investing generally doesn't come naturally. While it's not a perfect analogy, my Jordan sneaker collection is an example of diversification in your portfolio. Asset allocation and diversification may sound complex—but the concepts behind them are quite simple—and they are two cornerstone concepts for building a portfolio.
Different sneakers are like different asset classes.
After all, no one buys the same 10 pairs of Air Jordans. People buy different types of Air Jordans because they want to own various pairs for certain reasons, just like you buy different asset classes in your portfolio. For example, I own a pair of the Air Jordan 6 rings shoe in white and Carolina blue to match a Mavericks city edition t-shirt. I only bust those out when I go to a Dallas Mavericks game. I own another pair—Air Jordan 11 retro in black and white—that I save for dressy occasions, and I wear my Air Jordan 10 retro in cool grey in more casual situations when I want to look fly. Similarly, the basics of diversification and asset allocation are all about having different investments for different purposes.
What are diversification and asset allocation?
Diversification means don't put all your eggs in one basket. In investing, you can spread your risk by adding different types of investments to your portfolio that aren't likely to go up or down at the same time. In practice, this means owning a variety of stocks and/or bonds, each with different characteristics.
Asset allocation refers to the way you divvy up your money between various asset classes, such as stocks, bonds, and cash. Your asset allocation could range from aggressive to conservative and will help determine both your level of risk and your potential for gain. Here's a couple of examples of different types of asset allocation:
- Conservative asset allocation: This type of portfolio primarily holds investments that have less risk of loss, as well as lower potential for growth. These include investments like U.S. Treasury bonds, CDs, or other types of fixed income investments that can be more stable than stocks. These investments are typically more appropriate for an older person with a shorter time horizon to keep their money invested, or someone who has a short-term goal. These types of investments can also help you avoid wild swings up and down, and steady a stock portfolio.
- Aggressive asset allocation: This type of portfolio is made up largely of stocks, which can carry significant risk of loss—and higher volatility—but also the potential for big growth. This could be appropriate for someone young and saving for retirement because they can keep their money invested for the long term and ride out market ups and downs.
- Moderate asset allocation: This portfolio falls somewhere in between.
While my Air Jordan collection may not be as big as that of some sneakerheads, I have pairs that I'll pull out for specific occasions. And each pair plays a certain role in my overall collection, kind of like a diversified investment portfolio.
How diversification can help you.
When you invest in a mix of different types of investments, you are essentially lowering your risk of loss by spreading your money around. But it's also important to remember that diversification isn't always a slam dunk. It can't guarantee a profit or eliminate the risk of loss.
However, if you don't diversify, you're setting yourself up for a huge hit if your chosen investment falters. Here's an example: If you own one stock and it falls 20%, the value of your investments falls 20%. But if you own 10 stocks, and one falls 20% while the others are either flat or rising, you can significantly reduce your overall loss. So how much of one stock is too much? If any one investment equals more than 10% of your portfolio's value, that is typically known as a concentrated position, and you take action to diversify. I can hear the ref blowing his whistle now.
Identify what asset allocation may be right for you.
As you build a diversified portfolio, consider your tolerance for risk. How comfortable are you with temporary losses, which can occur?
My dad helped me learn the importance of wise money decisions.
Remembering back, as much as it pained me as a kid to not get a pair of Air Jordans, it taught me that you have to make wise money decisions. To help you stay out of foul trouble, here is a game plan to consider:
- Create a financial plan based on your goals.
- Save and invest to help you reach those goals.
- Build a diversified portfolio based on your goals, timeframe, and tolerance for risk.
- Minimize investment fees and taxes.
- Check on your investments at least once a year and rebalance your portfolio as needed.
- Ignore the noise you may hear in the daily financial news, stick to your plan, and stay focused on your long-term objectives.
Now let's get started, the shot clock is ticking. Lace 'em up!