The concept of diversification in the investment world has the same meaning as the saying, “Don’t put all your eggs in the same basket.” Diversification is an investment strategy that reduces portfolio risk while increasing your portfolio’s overall long-term return. It does so by spreading investments across different types of assets. Diversification is necessary because nobody can predict how different asset classes, markets, and individual companies will perform over time. Some assets will perform well during an economic downturn, while others will do poorly. However, the previous losers might become winners, and the winners become losers during the next downturn.
Diversification should be a part of everyone’s carefully planned long-term investment strategy. It will help you realize your financial goals, regardless of market conditions. This article will explain what diversification is, why it is important, and how to build a diversified portfolio with relative ease.
What Is Diversification?
Diversification is a risk management strategy that reduces the overall risk of an investment portfolio by spreading out your investment dollars across various assets, markets, and companies that have low or no correlations to one another. The idea behind this strategy is that diversification decreases the volatility of your portfolio because when one asset rises in value, another asset most likely will be decreasing in value, smoothing out the overall return of the portfolio as a whole.
If too large a percentage of your portfolio investments is in one individual stock or one industry, your portfolio risk is too high. If something goes wrong with that one stock or industry, you can lose most of your savings in a short period of time. Having a variety of assets reduces the risk of an individual asset hurting your portfolio.
In the investment world, lower risk typically means lower rewards. This is also the case with diversification. However, reduced risk often results in lower returns in the short term. This trade-off means that rapid growth and astronomical returns are out of the question in a diversified portfolio. However, in the long term, diversification results in a less volatile portfolio that shows slower but steady performance and returns and will enable you to reach your financial goals.
When diversifying your portfolio, you have to consider your risk tolerance and your expected time horizon. For example, if you are an aggressive investor and do not need your money for the next 10 to 20 years, you might want to invest the bulk of your money in stocks such as growth stocks and other higher risk/higher reward assets to maximize returns. On the other hand, if you are a conservative investor and worry about too much volatility in your portfolio and are close to retirement age, you might want to consider a portfolio that includes dividend stocks, large caps, and some more fixed-rate assets such as bonds.
Although diversification may seem complicated, it is essential to a portfolio’s success. However, it is important to remember that all investments carry risk. Therefore, while diversification reduces risk, it does not ensure a profit or guarantee against loss.
Why Diversification Is Important
The main goal of diversification is to reduce a portfolio’s exposure to risk and volatility. Reducing and managing risk and volatility will help you sleep better at night and paves the way for reaching your long-term financial goals. This is the reason why diversification should always be an important part of your investment strategy.
As an investor, you are exposed to two different types of risk; unsystematic risk and systematic risk. Unsystematic risk is also called diversifiable risk or asset-specific risk. This type of risk affects a particular asset or group of assets, such as an industry or a specific location. You can mitigate asset-specific risk by diversification. For example, a product recall is an unsystematic company-specific risk and can significantly reduce a stock’s price. Another example of unsystematic risk can be poor management performance in a company.
You can avoid unsystematic risk by acquiring stocks and other asset types from various companies across different industries and geographical locations. This way, if some businesses you have invested in face adversity and their value declines because of unsystematic risk, other businesses you have invested in will not be affected, and their values might increase. This often results in an increase in the total value of your portfolio in the long term.
The second type of risk your portfolio will be exposed to is systematic risk. Systematic risk, also called market risk, affects the overall market and does not just affect a specific security or a group of securities. Unfortunately, this type of risk is unpredictable, unavoidable because external factors cause it. All securities are subject to systematic risk, and this type of risk cannot be completely avoided by diversifying. Systematic risk is caused by economic, socio-political, and market-related events such as interest rates, recessions, and wars.
Systematic risk cannot be eliminated completely but can be managed to some extend by investing in different asset classes that don’t move in the same direction but perform differently in similar markets. Diversification is an investment approach used to balance the risks and rewards as some investments bring positive returns while others lose money.
Remember, diversification does not ensure a profit or guarantee against loss.
Ways to Diversify
Investors have several ways to diversify their portfolios, each with its own advantages and drawbacks. Some of the most common ways to diversify include diversification by asset class and within an asset class.
Diversification by Asset Class
The three primary asset classes in a typical investment portfolio are stocks, bonds, and cash.
- Stocks usually make up the bulk of an investment portfolio because they offer the highest long-term return potential. However, stocks are more volatile than most other asset classes, particularly in a contracting economy and short-term investment horizon.
- Bonds are less volatile than stocks and provide investors with a fixed income from interest payments. However, bonds only offer modest returns. During an expanding economy, when interest rates are low, their returns are meager at best. Bonds and stocks are said to be negatively correlated. This means that when bonds do well, stocks are declining, and when stock prices are rising, bond yields are falling. The most common types of investment-grade bonds are government bonds and corporate bonds. Please note that high-yield bonds, also called junk bonds, are highly volatile, have high default risk, and should therefore be avoided.
- Cash and cash equivalents are generally the most secure investment in terms of immediate and short-term liquidity and consistent returns. However, they have the lowest return rate of any investment, especially in an expanding economy when interest rates are low.
- Other asset classes like commodities, real estate or Real Estate Investment Trusts (REITs), cryptocurrency, and Exchange Traded Funds (ETFs) can help build a truly diversified portfolio. It is important to understand the risk involved in each of these alternative asset classes. To ensure you achieve the right amount of diversification, you need to understand how each asset class correlates to other asset classes in your portfolio.
Diversification Within Asset Class
Once you diversify your portfolio by asset class, you can further reduce risk by ensuring that you diversify further within each asset class. Here are some ways to diversify within an asset class.
Market Cap or Size – Market capitalization is a method to measure the size of a public company. It refers to the aggregate market value of a publicly traded company’s outstanding shares of stock. Diversification by market cap is a popular way of diversifying your portfolio.
Typically, companies are categorized in one of three broad groups based on their size; large-cap (market value of $10 billion or more), mid-cap (between $3 billion and $10 billion), and small-cap ($3 billion or less). Small-cap stocks typically carry higher risks but have a high return potential. Large-cap stocks typically are more stable during economic downturns but have a lower expected return. With the right mix of small-, mid-, and large-cap stocks, you can significantly reduce the risk in your portfolio. You can design your diversification strategy to fit your risk tolerance, time horizon, and financial goals,
Industry and Sector – Investing across different industries and sectors is another great way to diversify. Economic cycles affect different industries/sectors in different ways. The S&P 500 classifies stocks into 11 sectors. Of these 11 sectors, 9 sectors are mostly cyclical (offensive), and 2 sectors are non-cyclical (defensive).
Cyclical stocks are stocks that typically follow the ups and downs of the economy. So when the economy expands, these companies will prosper, but their stock prices will decline when the economy contracts. For example, companies in the technology and consumer discretionary sectors historically expand during economic upturns and contract during economic slowdowns. Cyclical stocks are more volatile and higher-risk than non-cyclical stocks.
The 2 sectors that are considered non-cyclical are the consumer staples and utility sectors. They will outperform the market even in economic downturns because consumers still need essential items such as toothpaste and electricity. Non-cyclical stocks will provide safety and are a good way to avoid losses when cyclical companies are suffering. However, keep in mind that they will not show high growth when the economy starts expanding again. Dependent on your risk profile and time horizon, you should include both cyclical and non-cyclical assets in your portfolio.
Investment Style – Another way to diversify your stock portfolio even further is by investment style. If you are a growth-oriented investor and are willing to take some risk, a large percentage of your portfolio should be in growth stocks. These types of stocks are expensive but offer high future growth potential. If you are more conservative, you should focus on a large percentage of value-oriented stocks that seem underpriced and undervalued. A combination of both types of stock can definitely reduce risk in your portfolio.
Bond Type – There are 3 main types of individual bonds categorized by the issuer; government bonds, municipal bonds, and corporate bonds, and each type has its own advantages, disadvantages, and risks. In general, corporate bonds are riskier than government-backed bonds, but they offer a higher rate of return.
Credit Quality – Bonds have varied levels of risk and creditworthiness. They can be divided into investment-grade bonds with high credit ratings (AAA, AA, A, or BBB) and non-investment-grade bonds, also called junk bonds or high-yield bonds. Non-investment grade bonds have lower credit ratings of BB, B, CCC, CC, and C. The lower the rating, the higher the potential return. An example of a AAA bond is the U.S. Treasury. U.S. Treasuries are essentially risk-free for individuals who hold the bonds until maturity. There is almost no chance the government will go bankrupt. However, the less risk, the lower the rate of return. Investors interested in the safety of their bond investments should stick to investment-grade bonds.
Maturity – You can diversify bonds by maturity date by including short-, intermediate-, and long-term bonds in your portfolio. This strategy is called bond laddering. An easy way to accomplish this type of diversification is to buy a bond ETF diversified by maturity date. This helps reduce the negative effects that rising interest rates can have on your bonds. Rising rates hurt all bonds but will hurt longer-term bonds the most.
Your risk tolerance, tax considerations, and overall financial goals will determine what the ideal bond mix is for your portfolio. Diversifying across different investment-grade bonds, maturity dates, and credit quality is a great way to reduce risk. It is advisable to stay clear of junk bonds as this type of bond is very risky and often defaults.
Stocks and Bonds
There are some ways to diversify that apply to both stocks and bonds. Here are the most common ways.
Geography – A diversified portfolio should incorporate stocks and bonds from companies and governments that get their income from different parts of the world or are located in different geographic regions. Geographic diversification assumes that financial markets in different geographic locations worldwide are not highly correlated with one another. Therefore, it reduces the risk of being over-dependent on one economy’s success and presents some income opportunities.
For example, when investments in developed western markets such as the US and Europe are declining because of a recession, investments in emerging economies with higher growth rates such as China and India might be increasing. Thus, building a portfolio with securities from stable developed foreign markets and more volatile developing markets will help you reduce risk.
Active versus Passive – Stocks and bonds can be further diversified by the management style used by the underlying companies. Adding both actively and passively managed funds to your portfolio will definitely make your portfolio more diversified.
In actively managed funds such as most mutual funds, the fund manager continuously tries to beat the market by buying and selling stocks to get the best return on investment. In contrast, in passively managed funds like ETFs and index funds such as an S&P 500 index fund, the fund manager’s main goal is to mirror the benchmark index’s performance as closely as possible, not to beat the market. Active funds often offer more security during economic downturns, while passive funds perform better during economic upswings.
Diversification Beyond the Common Asset Classes
Diversification can be expanded beyond the most common asset classes. Some investors achieve this by including funds such as commodity-focused equity funds and Real Estate Investment Trusts (REITs). These types of funds do not only increase diversification but can also offer some protection against the risk of inflation. If you don’t have the time or knowledge to build a diversified portfolio, you can follow a single-fund strategy. An example would be an asset allocation fund. An asset allocation fund attempts to create an optimal portfolio given your risk tolerance and time horizon.
There are various types of asset allocation funds. The most common ones are target-date funds and balanced funds. Target-date funds are customized to the individual investor’s age and retirement year. They get automatically rebalanced when needed to align with the investor’s retirement age. Many companies use target-date funds as the default for their employees’ 401K plans.
Limitations of Diversification
While the benefits of diversification are overwhelming, there are drawbacks as well. Some people believe that the more diversification, the better. That is not true. Over diversification can be a real problem. First, it can take a significant amount of time and effort to manage a diversified portfolio. This is particularly true when you have various investments and holdings to take care of. The more holdings you have, the more difficult and time-consuming it will be to manage your portfolio effectively.
Secondly, diversification can also be expensive. Every type of investment has costs associated with it. For example, when you purchase and sell holdings regularly, you will incur different brokerage commissions and transaction fees. These costs will reduce your overall return.
Lastly, diversification can limit your short-term returns. Lowering the risk exposure of your portfolio can definitely reduce your return potential in the short term. However, over the long term, diversified portfolios typically show steady growth.
Diversifying offers you good protection against market volatility and reduces risks. However, it does not guarantee high returns and does not prevent losses, especially short-term losses during economic downturns. Over the long term, diversification will help increase returns. A successful diversification strikes a balance between risk reduction and a long-term increase in portfolio value.
How to Build a Diversified Portfolio
Building a diversified portfolio may seem overwhelming and difficult, particularly when you don’t have a lot of time and experience. Luckily, this process does not have to be complex. Here are some simple steps to start your financial plan, build a diversified portfolio and become financially independent.
Step 1: Assess your current financial situation and then create your short term and long term financial goals
It is essential to assess your current financial situation because your current financial health can have a big impact on your plans. First, take inventory of your current assets, outstanding debt, current investments, if any, and any possible upcoming large expenses. Only then start creating a comprehensive investment plan that meets your values and beliefs. Your plan should include clear, quantifiable goals and priorities for both the short-term and the long-term.
Step 2: Determine your time horizon and risk tolerance
Before selecting your ideal security mix, you have to consider your age and your desired risk level. Unfortunately, it is often not easy to decide what level of risk you are comfortable with.
Typically, if you are still young and have sufficient time to wait through the rise and fall in the market, you should allocate a larger portion of your portfolio to stocks because your portfolio will have ample time to recover if something goes wrong. However, if you are close to retirement and need your money relatively soon, you should allocate a larger part to less volatile assets.
You always have to be comfortable with the investment you make. If you are young and get overly excited and nervous by fluctuating asset values, you might want to invest in less risky assets such as dividend stocks, value stocks, and bonds. Then, after you get used to the ups and downs of the market, you can increase your risk tolerance. Allocating more money to higher-risk investments will be less scary and increase your returns.
Step 3: Select a diversified asset mix
Once you have identified your investment goals, risk tolerance, and time horizon, you can start picking your investments. If you have no time, no interest, and are uncomfortable making investment decisions, it might be a good idea to hire a financial advisor to do the work for you. On the other hand, if you want to do it yourself but do not have the expertise to build and manage a fund with individual securities, there are some relatively easy ways to build a diversified portfolio. Here are some suggestions.
Index funds – Including index funds as part of your portfolio can be a cost-effective way to build a diversified investment portfolio. Index funds are easy to purchase, and they are low-cost. In addition, they follow a market index such as the S&P 500 and merely try to mimic its performance. As a result, they are lower risk than investing in individual stocks.
Mutual funds – You can also consider investing in a mix of mutual funds and ETFs to increase diversification and reduce risk and volatility. However, do not put more than 25% of your funds in any one type because you will want to spread the risk across different asset classes.
Asset allocation funds) – One of the easiest ways to build a diversified portfolio is through an asset allocation fund. This is typically a single diversified fund containing securities across different asset classes. This type of funs attempts to create an optimal portfolio based on your risk tolerance. An example is a balanced fund. A balanced fund invests in a pre-determined mix of stocks and bonds (i.e., 80/20, 70/30, or 60/40) at all times and rebalances automatically.
Robo-advisors – Another way to quickly build a diversified portfolio is through a Robo-advisor. These are digital platforms that will do the work for you. They will buy and sell securities, manage them, and rebalance your portfolio when necessary. You will only need to answer a few questions about your risk tolerance, investment goals, and time horizon when setting up the account, and the Robo-advisor will pick the right mix of assets to build your diversified portfolio.
Manage and Rebalance Your Portfolio
Once you have defined your financial goals and selected a mix of assets for a diversified portfolio, you might think that you are done and that you can now sit back and watch your portfolio grow. But, unfortunately, nothing is further from the truth! When investing for retirement, your work is never done unless you hire a financial advisor/manager who will do the work for you.
You now have to start managing your portfolio. This includes monitoring and measuring your portfolio’s performance and risk exposure regularly (quarterly or semi-annually) against the goals set. Then, at least once a year, you should review your portfolio to ensure that your asset allocation still matches your selected risk-return profile. If not, and there has been a significant shift in allocation, and a few assets have a higher weight at the expense of other assets due to market fluctuations, you need to rebalance your portfolio. This is particularly important when you are trying to achieve a balance of growth and income.
A common strategy is to consider rebalancing your portfolio when a part of your asset mix has shifted away from its target allocation by over 10 percent. To rebalance your portfolio, you will have to sell some investments from the overweighted asset classes and buy other investments for the underweighted asset classes. This will reset your portfolio to the desired allocation to ensure the diversification makes sense.
Besides a regular yearly portfolio review, you will also want to review your portfolio any time your financial situation has changed significantly, through things like job changes, deaths, divorce, or a change in time horizon. When necessary, you need to update your plans and goals and adjust your asset allocation to ensure that the right investment strategy is in place to reach your financial goals.
By spreading your investments across different assets, diversification helps reduce the risk and volatility in your investment portfolio. Diversifying your portfolio does not have to be complicated and can be done in many different ways. For example, you can spread your investments across various asset classes, market caps, sectors and industries, and different geographic locations.
Building a diversified portfolio is a great way to protect investments and improve your chances for long-term growth. However, diversifying a portfolio is not a “set and forget” activity. Having a comprehensive financial plan that takes your risk tolerance and time horizon into consideration is only part of this successful strategy. The other part is the ongoing regular monitoring, measuring, and rebalancing of your diversified portfolio that is necessary because of market volatility and unexpected changes that may occur in your current situation.
Also, make sure to pay attention to transaction fees and commissions, as these costs will reduce your overall returns. Asset allocation ETFs and mutual funds can be cost-effective ways to have a diversified portfolio without having to spend a lot of time planning, as these funds invest in a mix of bonds and stocks and rebalance automatically. Target-date funds take this even a step further by adjusting the mix consistently as you get closer to your retirement age.
Always remember that although diversification reduces risk and volatility while growing your portfolio in the long term, it is not designed to maximize returns and does not guarantee profits or prevent losses.