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Invest Smarter: Diversify

Many investing principles are based on home-spun wisdom. Take the concept of diversifying your investments. It’s just like grandma said: "Don’t put all your eggs in one basket." Think about it: If you have an entire portfolio of the same stock, one blip in the stock market could turn your nest egg into scrambled eggs.

One key to smart investing is to diversify. Diversifying increases the chance that even in an economic downturn, you will still have some profitable investments to pull you through. There are three ways to diversify:

By Asset Class;
Within Asset Class; and
By Time Horizon.

By Asset Class

There are three basic asset classes: stable values, bonds, and stocks. There are also investment funds, which may be of just one category or a combination of asset classes. Generally speaking, when the stock market is up, the bond market is down, and vice-versa. Since stocks and bonds tend to move in opposite directions and stable values are steady, striking a balance between the three will cushion your portfolio against investment swings in one asset class.

Stable Values

Stable values are relatively low-risk investments, although not guaranteed. The objective of stable values is to protect your principal investment while providing some interest on the money. You’ve most likely already invested in a stable value, such as a savings account, money market fund or Treasury bills. Stable values are less vulnerable to market risk than stocks or bonds, but more vulnerable to inflation risk. Historically, stable values have earned less of a return than other asset classes.

Bonds

Bonds act like IOUs for a loan you make to a company, bank, or government that borrows money. The borrower promises to pay you back the amount of the loan (the bond’s face value) on its maturity date. You’re normally paid interest while the borrower uses your money and then repays the original investment on the maturity date. Bonds usually have a fixed interest rate, meaning it does not change over the lifetime of the bond, and market interest rates do not influence the interest rate. However, market interest rates influence the value of your bond. When interest rates go down, the value of your bond goes up (because it is now earning higher interest than most other investments) and vice-versa. Bonds can be somewhat vulnerable to market risk and inflation risk, so they are considered riskier than stable values. But bonds historically have a higher rate of return than stable values.

Stocks

Stocks are ownership units of a company. Stock prices vary depending on what investors are willing to pay based on many factors. When you invest in stocks, you are investing with the hope that your stock will increase in value. Stocks are typically riskier over the short-term but historically offer greater long-term returns than other asset classes. However, stocks do not out-perform stable values and bonds every year. Overall, stocks are the most vulnerable to market risk and the least vulnerable to inflation risk.

Investment Funds

Investment funds are the most efficient vehicle for diversifying your portfolio. Investment funds, like those in PSEG’s Thrift and Savings Plans, are groups of investments managed by independent companies. An investment company combines the money of many investors who have similar objectives. The group of investments may be made up of a single asset class or a combination of all three (stable values, bonds, and stocks). Professional fund managers monitor the investments to make sure the fund stays on track with the investors’ goals. Professional guidance and group buying power make these funds advantageous for investors.

Within Asset Class

Although your investments should be at least diversified by asset class, it’s also a good idea to further diversify within each asset class. For instance, if you want to enhance your diversification by adding stock to your investments, do not buy just one type of stock. Buy all three classes of stock:

Large company stocks—These stocks are from well-established U.S. companies with long corporate histories and leadership positions in their industries. Many produce dividends, provide a steady income stream, and are listed in the major stock exchanges. If you’re interested in this type of investment, check out the Large Company Stock Index Fund in the Thrift and Savings Plans.

Small company stocks—These stocks are from young rapidly growing businesses that tend to fluctuate more in value than large company stocks. These stocks can provide a return on your investment when they grow in market value as opposed to the more regular dividends paid by large company stocks. These stocks are usually listed over-the-counter (that is, not on the major stock exchanges) or through the National Association of Securities Dealers Automated Quotation (NASDAQ). If you’re interested in this type of investment, check out the Small-Cap Index Fund and the Mid-Cap Index Fund in the Thrift and Savings Plans.

International stocks—These stocks are from companies headquartered outside the United States. Like stocks in the U.S. market, international stocks are influenced by general business and economic conditions, but foreign market cycles are likely to differ from those in the United States. Currency fluctuations also have an impact on price movement of international stocks. These stocks are listed on overseas exchanges or on the New York Stock Exchange as American Depository Receipts. If you’re interested in this type of investment, check out the Institutional Developed Markets Index Fund in the Thrift and Savings Plans.

By Time Horizon

Aside from diversifying by asset class, time is also useful in diversifying your investments.

Investments that have greater short-term market risk tend to have a greater long-term payoff, and vice-versa. By picking a mix of investments mindful of when they are likely to pay off, you can take advantage of time and return. Getting the right mix to support your investment goals will cushion you against short-term loss, while ensuring that inflation doesn’t eat away at your investment, and that you are positioned for future growth.

Here’s an overview of the asset classes, the general time frames in which they produce the best returns, and the Thrift and Savings Plans investment choices that fall into those categories:

Some investors try to "time" the market rather than diversifying their investments over time. However, 92% of the return of any investment is based on asset class, not market timing. And for market timing to work, you have to be able to predict the stock market’s direction when you buy and sell the stock, which is virtually impossible. During the 1980s, the average return of the stock market was 17.5% per year. However, if you took your investments out of the stock market on only 40 of its best days, your return would have been just 3.9% per year.

Want a more reliable return on your money? Take advantage of dollar-cost averaging—a systematic approach that takes out the guesswork of investing. Contributing regularly to the Thrift or Savings Plan is a good example of this practice. By investing a set amount of money on a regular basis, you reduce the risk of poor market timing—missing out when the market’s performing well or overpaying for an investment.