As an investor, you have certainly heard the term “diversification,” and you’ve probably heard that you should have a diversified investment portfolio. But what does that actually mean in practice? What does it not mean?
At its most simple, diversification is not putting all of your eggs in one basket. It is an investment strategy intended to reduce risk over the long term. By investing in a variety of areas, you are essentially reducing the risk you’re subjecting your portfolio to. If one area of the market performs poorly, your investments elsewhere will lessen the blow. Additionally,
- Diversification means never being at the top but also never being at the bottom.
- You will always be unhappy with one part of your portfolio.
- You can achieve diversification by building a portfolio of different investments or by investing in a diversified mutual fund or ETF.
- In terms of investing, it is about as exciting as watching grass grow or watching paint dry. You will not get the thrill of meme stock investing on Robinhood!
Some investments will have a higher yield but greater volatility, and others will reliably produce a steady income for you but at a lower rate of return. A diversified portfolio can allow for a larger withdrawal rate from your portfolio when you retire in retirement rather than just spending the investment income of the portfolio.
How to Build Diversification Into Your Portfolio
The key to building a diversified portfolio is to combine parts of the market that have low or negative correlations with one another. When one investment is performing poorly, you will still have exposure to investments that are performing better.
Strategic asset allocation helps to generate an appropriate rate of return at a given level of risk. There are many different ways to slice the investable market, and most often slices are determined by asset class. Asset class allocations will be chosen and then rebalanced regularly across the portfolio.
Some common examples of Asset Classes:
- Equities (e.g. Stocks)
- Fixed Income (e.g. Bonds)
- Cash and Cash Equivalents
- Real Estate
These asset classes typically have low correlations to each other and are therefore good building blocks of a diversified portfolio. Approximately 90% of the performance of a portfolio is determined by its asset allocation and overall market returns rather than selection of a particular equity fund, market timing, or tactical asset allocation.
Additional Ways to Diversify Your Portfolio
Diversification can also be achieved by buying investments in different countries, industries, sizes of companies, or term lengths for fixed income investments.
If an individual retail investor wants to build her own diversified portfolio of individual stocks, It can often be difficult, time consuming, and may incur more transaction costs. Even when choosing mutual funds, retail investors may make common mistakes, like:
- Allocating the account equally among mutual funds, like picking 5 mutual funds in your 401k and allocating 20% of the account to each one.
- Hold funds at different custodians or mutual fund companies – depending on the mutual funds chosen, you may have substantially equal exposure to the market but just at different institutions. You need to “look under the hood” of the fund holdings.
Is Diversification Risk-Free?
Diversification does not mean that your portfolio will not lose value. The aim of diversification is to reduce “unsystematic risk.” It is not possible to diversify away from “systematic risk,” or risk of losses in the overall market. Unsystematic risks are risks specific to an investment that are unique to that holding. Some examples include:
- The risk related to a specific company based on the nature of its company and what it does in the market.
- The risks related to a specific company or organization’s financial health, liquidity, and long-term solvency.
- The risk related to breakdowns in the processes of manufacturing or distributing goods.
- The risk that legislation may adversely impact the asset.
Invest in a Support Team
A successful investment portfolio does not come from anticipating the next recession or market correction. Success comes from discipline, diversification, proper allocation between stocks and bonds, tax-managed investing, and research-based dimensions of expected returns.
Diversification is truly important to grow your portfolio, and to allow for the income you’ll need in retirement. But behavioral research shows that our brains are not always built for making rational investment decisions. An advisor with a disciplined investment plan built for your goals and in your best interest can guide you through the inevitable market volatility and uncertainty.
If you’d like to discuss your investment plan, or seek professional help in building a diversified portfolio, then please do get in touch – we would welcome the chance to chat with you.