Getting your money right: How to diversify an investment portfolio to reduce risk and potential losses

Welcome to Select's newest advice column, Getting Your Money Right. Once a month, financial advisor Kristin O'Keeffe Merrick will be answering your pressing money questions. (You can read her last installment here on how rising interest rates impact your investment portfolio.) Have a question you want to ask? Send us a note at AskSelect@nbcuni.com.

Dear Kristin, 

With the recent downturn in the stock market, I am trying to look for ways to protect my portfolio. I know of the adage, "diversify, diversify, diversify" but what does that actually mean? And how do I go about diversifying to protect my investments in volatile markets? 

Signed, 

Diversifier from Denver

Dear Diversifier, 

During the financial crisis in 2007-2009, I was a currency trader at a large international bank and saw some really crazy market occurrences that still make my blood curl. During that time, we witnessed an unprecedented plummet in asset prices as we were on the brink of total market collapse.

When Lehman Brothers went bankrupt, we hired one of their former currency traders — on his first day, he cried. Yes. A grown man cried to me on his first day of work. Why? Because he had lost his entire life savings. Prior to the crisis, the culture at Lehman Brothers was to accrue company stock and not sell it. As a result, when Lehman collapsed and the stock went to zero, many people, including my new colleague, lost everything.

This is a cautionary tale of why we need to diversify our portfolios. The Lehman employees at that time had concentrated their portfolio into one stock, which seriously endangered their financial well-being. 

When you think about building an investment portfolio, it helps to imagine a spectrum that ranges from concentrated to diversified. A concentrated approach is analogous to putting all your eggs in one basket, while an extremely diversified portfolio means you own many securities ranging from stocks and bonds to currencies and commodities. In my opinion, neither end of the spectrum is advisable. 

I think I have made my case as to why you wouldn't want to have too much concentration in your portfolio, so let's shift toward what diversification actually means and why it's important.

Diversification is the concept of putting your money into various types of investments that often don't react the same way and at the same time to market volatility. A diversified portfolio could have different types of securities, such as large cap stocks, small cap stocks, international stocks and stocks from all types of different industries. If your existing portfolio only holds five U.S. based tech stocks, for instance, it's not considered to be diversified. However, if you hold a U.S. tech stock, as well as stocks from an energy company, a real estate company, a small chip maker from Taiwan and gold, you could argue that your portfolio is diversified. 

If you want to easily create a diverse portfolio, consider using a robo-advisor, which will use its algorithm to automatically build you a custom portfolio based on your risk tolerance, investing goals and time horizon — plus they'll automatically rebalance your investments over time. Select ranked Wealthfront and Betterment as some of the best robo-advisors.

For those who want a more hands on approach, you could buy an index fund or mutual fund through a broker like Charles Schwab or Vanguard.

Adding different securities to your portfolio to reduce risk is the act of diversification. One way to diversify is by hedging, or "putting on a hedge" — it's a buzzy Wall Street term but it shouldn't be a scary word.

Hedging your portfolio simply means you are reducing unsystematic risk, which is a company or industry-specific risk that is inherent in each security. For example, an unsystematic risk for a car company would be a product recall. While a recall would be an issue for that specific company, it wouldn't be for the entire automobile industry or the overall economy. 

A timely example of hedging would be if you owned energy stocks in your portfolio. Given the overall market environment, most stocks and bonds have corrected lower while energy-related securities have rallied. This is a scenario where you likely have lost money on your stocks and bonds but have made money on your hedge (energy position).

The general rule about diversification is that it reduces your unsystematic risk but does not eliminate all of your risk. The sibling to unsystematic risk is systematic risk, which can be attributed to broad market factors such as inflation and higher rates, as we have witnessed over the past few months.

While it's extremely difficult to eliminate systematic risk, it's possible through some hedging strategies. For example, an investor can use options as a way to hedge. An option is a security that is used to protect your investment from large downside moves. However, to buy an option, you have to pay a premium.

You must keep that premium payment top of mind when deciding if the economics make sense to put a hedge on. Remember that a reduction in risk overall could be a good strategy, but it will also reduce your potential profits.

Note that options are complicated and not for novice investors. Do not use options if you are new to investing unless you're working with a financial professional. 

While diversification is important, it's crucial that you don't over diversify. Often I will look at new clients' portfolios and one of the mistakes they (or their former financial advisors) have made is that it has too many securities.

Often, they own more than 10 exchange-traded funds, or ETFs, and/or mutual funds in the same portfolio. Remember that each mutual fund or ETF could own 50 to 500 securities, meaning if you own 10 mutual funds, you could actually own over 5,000 holdings.

It's very hard to make decent returns on your investments when you own that many securities. Think about cooking your favorite dish. If you use too many different spices, it becomes difficult to taste anything and you'll eventually ruin the meal. This is similar to over diversification. 

Overall, you want to be somewhere on the diversification spectrum, but not overdo it. If you own too much of one stock, you should put a plan in place to liquidate some of it and put the proceeds into a more diverse portfolio.

Note, however, that there are tax consequences when it comes to reducing your position so make sure to work with a financial professional and find out the best way to reduce some of your positions before hitting that sell button.

I hope this helps clear up a few things. I know this market has been a doozy but let's hope for better days ahead. Good luck!

Kristin O'Keeffe Merrick is a Financial Advisor and money expert at her family-run firm, O'Keeffe Financial Partners, located in Fairfield, NJ. 

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