No matter the size of your portfolio, all of your investments carry some degree of risk.
Stocks, bonds, exchange-traded funds (ETFs) and mutual funds can lose value, sometimes all their value, if market conditions go haywire.
The key to a sound investment strategy is to mitigate as much risk as possible. One of the most effective risk management methods is portfolio diversification.
While portfolio diversification may sound intimidating, it’s not as scary as you may imagine.
However, diversification isn’t as simple as tossing your money into various different assets. Like any other investments, the technique of diversification involves conducting a lot of research to make smart financial decisions.
Keep reading to discover what it means to have a diversified portfolio and why it’s important. Additionally, we’ll provide actionable tips to help you get started.
What Is Portfolio Diversification?
Portfolio diversification, also known as investment diversification, is a strategy of extending your investment money across various types of assets to reduce your overall risk.
Diversification can take many forms. You may purchase various investments across different industries, economic sectors or geographic locations.
Additionally, you can diversify through a variety of asset classes, which may give your portfolio an extra boost.
Diversification is a subset of asset allocation, which means how much of your portfolio is invested in different asset classes or groups.
For example, your asset allocation may consist of 70% stocks, 20% bonds and 10% cash equivalent assets, such as a money market account.
Asset allocation and portfolio diversification are some of the fundamental principles of investing. By not putting all your eggs in one basket, you protect your portfolio against market volatility, and it keeps you committed to your long-term investing goals.
Why Is Portfolio Diversification Important?
All investments carry some degree of risk. The main reason to diversify your portfolio is to reduce your risk while increasing the potential for overall return. Diversifying your investments allows for a stronger portfolio that will better handle the market swings.
If one of your assets is performing poorly, the hope is that you can control the damage via your other investments that are performing well.
That is not to say that the asset that is down in value can’t redeem itself. Depending on market conditions, one asset can perform well and others not. That shift can happen rather quickly.
Let’s look at a hypothetical scenario. Let’s say Jennifer Doan has 100% of her investments in Acme stock. Sarah Weaver also invested in Acme stock, but only 50% of her portfolio is invested with them, and the rest is split through various bonds, mutual funds and ETFs. Suddenly, Acme goes under, and the value plummets.
In this scenario, Doan would have lost all her money invested with Acme, while Weaver would have been able to weather the storm with her well-diversified portfolio.
While that scenario is a hypothetical situation, similar events have happened in real life.
During the 2008-2009 economic collapse, the U.S. entered into a bear market and various types of investments lost value, but diversification helped some individuals from complete portfolio losses.
Diversification By Asset Class
We’ve discussed what portfolio diversification is and why it’s important, now let’s see how it may look in practice. There are many different investment options, but two main ways of diversifying your portfolio.
- Among asset classes: Diversifying your investment portfolio among asset classes is a technique that spreads your money across the three major asset classes (stocks, bonds and cash equivalents).
- Within an asset class: This approach spreads your money across a variety of investment options within a specific asset class. For example, you may invest in large and small companies in the stock market. This technique helps you balance the risks and rewards of asset classes as well as the investments within the class.
In addition to the three main asset classes, there are other asset classes such as real estate (property), commodities (natural resources, agricultural products or precious metals) and alternative investments. These asset classes are separate from the others because they are generally less likely to be influenced by the stock market. Thus, those investments are a good option for diversifying your portfolio.
Tips For Building A Diversified Portfolio
There is no one-size-fits-all approach to portfolio diversification. Everyone’s financial situation, risk tolerance and overall goals are different. It’s best to consult with an investment professional so they can help steer you in the right direction.
With that said, there are some actionable steps you can take to get yourself started. Let’s delve into the four best tips for building a well-diversified portfolio.
Strategic asset mix
To create a diversified portfolio, you’ll need to ensure your asset mix is aligned with your long-term investment goals, financial needs, risk tolerance and comfort with volatility.
The simplest way to achieve asset mix is by purchasing ETFs or mutual funds. ETFs and mutual funds are beneficial because they essentially act as a basket of stocks. Thus, providing your portfolio with immediate diversification.
However, as mentioned previously, you shouldn’t purchase assets for the sole purpose of diversification. Each asset trades differently, so you’ll want to conduct proper research before throwing money at a specific investment option.
Another viable option to consider is diversification through index funds. Index funds include stocks that track the returns of a market index, such as the S&P 500. While you’ll be a little more restricted with diversification through index funds, it’s still a worthy option to consider.
Remember, the key to a well-diversified portfolio should include stocks, bonds, ETFs, mutual funds and cash equivalent options.
Diversify within individual types of investments
Aside from implementing a strategic asset mix into your investment portfolio, you may want to consider choosing investments with varying rates of returns.
This approach can get a little tricky when you’re purchasing single stocks since you’ll want to invest a good amount of money to make the trade worthwhile. As an example, you may not want to spend $15 to secure one share of stock for $250. Investing more can cut down the money you spend on fees.
When you consider investing in stocks, it’s wise not to focus on acquiring single stocks. Instead, you should look for different stocks within varying sectors.
Think about investments with varying risks
When building out a well-diversified portfolio, you may want to consider choosing options with varying rates of return. This tactic may help provide significant gains on specific investments in the event of losses from other options.
While one of the goals of investing is to mitigate as much risk as possible, you shouldn’t limit yourself to blue-chip stocks only.
An excellent approach to this technique is to consider investing in foreign stocks. Although, it’s important to note that stocks from around the globe may perform differently than domestic stocks.
A healthy balance of international and domestic stocks may help mitigate risk when the market hits a downturn stateside. You may want to consider this later on when your portfolio is a little more established.
Consistently rebalance your portfolio
Diversification isn’t a set it and forget it task. You should regularly meet with an investment professional to review your portfolio and adjust accordingly. If you avoid rebalancing your portfolio regularly, you put yourself at a greater risk.
Let’s look at another hypothetical situation and the effects of not rebalancing your portfolio. While the investment options in this hypothetical situation are not real, we’ll use the real-life historical monthly data from December 2000 to December 2020 to illustrate the effects of not rebalancing.
Sarah Weaver, in December of 2000, had a healthy mix of stocks (50%), bonds (40%) and cash equivalent (10%) in her portfolio. She did not rebalance her portfolio for 20 years, and her mix now looks like stocks (67%), bonds (29%) and cash equivalents (4%).
Her bonds and cash equivalent options got diluted while her stocks increased. As a result, putting her portfolio at a higher risk at the end of 2020. She is at a greater risk because stocks have historically had greater price swings than bonds or cash-equivalent options.
Everyone’s portfolio, financial goals and needs are different. There is no one specific guideline for rebalancing your portfolio.
With that said, reviewing and adjusting your portfolio a couple of times per year is a good rule of thumb to follow.
Consult With An Investment Professional
Portfolio diversification is a fundamental principle of investment management. The name of the game is to mitigate as much risk as possible. Through diversification, your portfolio is better equipped to handle the market swings. Diversification may help you reach your overall investment and financial goals quicker.
Use this article to help guide you through the beginning stages of diversifying your portfolio. As you get more involved with investing, you may want to consult with an investment professional to help steer on the path to financial success.
Arizona Central Credit Union’s Investment Services Team is ready to help you meet your investing goals. Contact one of our investment professionals at 602-523-8408 for a no-cost, no-obligation meeting.
