What is diversification and a diversified investment portfolio?
Even novice investors have probably heard of the concepts of asset allocation and diversification, but building a truly diversified portfolio may take a little more work than you think. Taking the time to know what diversification means, and how it is achieved, can make a significant difference in the long-term performance of your investment portfolio. While the old saying, “Don’t put all your eggs in one basket” is wise investment advice, you should go further and say, “Don’t put all your eggs in only a few baskets either. Instead, invest in many baskets and hold a substantially diversified portfolio based on your long-term asset allocation strategy.”
- know what true diversification means
- realistically identify your capacity for risk
- maintain a disciplined, consistent approach
- decide whether alternative investments are appropriate
- regularly monitor and rebalance your portfolio
- try to time the market
- make investment decisions in isolation
- neglect specialty asset classes
- forget to diversify within asset classes
- ignore fees and expenses
Do know what true diversification means
To hold a properly diversified portfolio, you first need to understand what investment advisers mean by “diversification.” While it’s true you shouldn’t invest your entire portfolio in only a few stocks, a portfolio holding 100 stocks of the same type is not truly diversified either. To be diversified, a portfolio should be composed of different types of asset classes. The two broadest asset classes are equities (such as stocks) and fixed income securities (such as bonds).
Equities generally offer higher returns, but are more volatile. Fixed income securities are more stable, but don’t produce as much in the way of returns. By holding a mix of both types and, when appropriate, alternative investments, an investor can balance stability and growth (that is, risk and return). These broad asset classes also include sub-categories, such as short- and long-term bonds, and large market capitalization (large-cap), and small market capitalization (small-cap) stocks. To be truly diversified, you should own a mix of different types of assets within the broad categories of stocks and bonds, including specialty asset classes such as natural resources and real estate equities.
Do realistically identify your capacity for risk
Investment risk takes many forms. Often, investment advisers use the words “risk” and “volatility” interchangeably. The more volatile an investment, the greater the chance that its return in a given period will vary from the owner’s expectations. Volatility tends to be much greater over short periods. Therefore, the risk of major surprises affecting the total growth of your portfolio is less (but certainly not zero) over extended time horizons. Virtually every analysis shows that the best approach to minimize risk is to hold a well-diversified portfolio over a long period of time.
Investors often focus too much on the expected return of their portfolio. While the expected return is important, you must also consider the amount of risk that you need to assume in order to achieve that expected return. In general, the higher the expected return, the more risk you must take on to achieve it. Different levels of risk will be appropriate for different investors, depending on their life situations, goals, and temperaments. When planning your investment strategy, it is important to be truthful with yourself in evaluating how much risk you can responsibly manage, and how willing you will be to stay the course through the ups and downs of the market cycle. Said another way, you should determine how much short-term volatility you are willing to accept in the pursuit of higher expected returns in the long term.
Do maintain a disciplined, consistent approach
One of the best ways to mitigate a portfolio’s risk is to maintain a focus on long-term results, rather than reacting to short-term movements in the market. Proper diversification comes from maintaining an asset allocation—that is, a pre-determined mixture of different types of assets. Rather than jumping on a trendy new stock or trying to profit from a “hot” sector, you should carefully select assets that meet your risk-return profile and fit into your overall asset allocation strategy.
When the market takes a downturn, resist the urge to panic and sell or to completely reconfigure your asset allocation. Instead, stick to your investment plan unless, and until, there is a material change in your situation or financial goals. Don’t let external market factors, which are almost always temporary and out of your control, drive your investment decisions.
Do decide whether alternative investments are appropriate
Alternative investments may include assets such as private equity, venture capital, and hedge funds. These investment often do not move in tandem with other asset classes, so they can provide a substantial diversification benefit. However, such investments are not appropriate for all investors. Even for investors who are well-suited for alternative investments, financial advisers generally suggest you limit your total commitments to no more than 10 or 15 percent of your total portfolio because of the risks involved.
While alternative investments offer investors the potential for above-average returns, this potential brings with it much higher risk than that associated with traditional investments such as stocks and bonds. In general, money committed to alternative investments cannot be withdrawn at the investor’s discretion and may come with an increased likelihood of a loss of principal. Alternative investments also often have much higher fees, including performance-based fees that can substantially eat into your net return. It is important to understand the risks, as well as the potential reward, of such investments. When they are appropriate, alternative investments can be an important part of a well-diversified portfolio.
Do regularly monitor and rebalance your portfolio
Once you have properly diversified your portfolio, the key to maintaining it is regular monitoring and, when appropriate, rebalancing. When rising markets lead to an over-concentration in one asset class, this is a signal to reduce your stake in that category. Conversely, when falling markets leave a segment under-represented, you should increase your investments in that segment. This is called “rebalancing the portfolio,” and the practice is an important part of any sound investment strategy. Research suggests that rebalancing provides a higher risk-adjusted return than leaving a portfolio to its own devices. You should take a disciplined approach to rebalancing, by buying or selling an asset class when it deviates from its target allocation beyond a predetermined range. This discipline will ensure that your portfolio does not become overexposed to one investment type or asset class, thereby maintaining the portfolio’s diversification.
Do not try to time the market
It is vital to maintain your asset allocation strategy unless your financial objectives or situation materially change. A well-diversified portfolio is designed to withstand the financial markets’ ups and downs over the long term. When investing with a long-term focus, the most significant risk is that changed circumstances or a severe market decline might prompt you to liquidate your holdings at an inopportune time. This locks in your losses, and makes it difficult for you to achieve your expected long-term returns. A growth-oriented portfolio will always include some element of volatility. Avoid emotional reactions to market changes and attempts to guess what the market will do next. Keep focused on a longer time horizon and remember that a diversified asset allocation strategy takes time to achieve the results you expect.
Do not make investment decisions in isolation
Your investment decisions should function as a component of your overall financial goals and circumstances. This is why there is no magic formula for a portfolio’s asset allocation or diversification. Every investor is different, and the most effective investment plan will work in harmony with your needs for cash flow, long-term growth, estate planning, taxes, and other financial concerns. Don’t ignore other areas of your financial life when making decisions about your portfolio. You should also be mindful to manage all of your assets as one integrated investment portfolio, rather than taking an account-by-account approach. Your asset allocation should consider all your accounts together, allowing you to make thoughtful choices about which accounts will hold which types of assets. For example, you may want to hold your highest income or highest growth assets in tax-deferred accounts, such as IRAs and 401(k)s, to minimize your current tax burden. This concept is known as “asset location” and should be a part of your overall diversified asset allocation strategy.
Do not neglect specialty asset classes
Many investors fall into the trap of investing only in assets that are familiar to them. However, a properly diversified portfolio should contain allocations to multiple assets classes and sub-categories. For example, a diversified portfolio should include an allocation to international investments. Historic returns of international stocks have been similar to those of U.S. stocks, but with fairly low correlations to the U.S. stock market. Investing outside the U.S. also provides a hedge against the U.S. dollar. Within this asset class, you should have sub-allocations to various regions, such as Western Europe, Latin America, Canada, Australia, Japan and other areas in the Pacific basin. When investing in international equities, you should consider using mutual funds or other investment vehicles that concentrate on a single region or country, such as a fund that invests solely in Japanese stocks. International markets are very different from country to country. Fund managers who focus on one area can have a greater understanding of their specific market than do managers who diversify across the world.
Often, a well-diversified portfolio should also include allocations to the real estate and natural resource sectors. While these are equities with the potential for appreciation and the capacity to generate income in their own right, they also serve as a hedge against a lengthy period of poor performance in the broader stock and bond markets. These investments also tend to perform better than others during times of high inflation. While buying pure commodities, such as oil and precious metals, will also provide this benefit, you will often do better to forego direct exposure in favor of enterprises that sell or extract the underlying hard asset. These businesses can generate profit even if commodity prices decline, by cutting costs or by investing in research and development to find alternative products.
Do not forget to diversify within asset classes
Diversifying within an asset class is crucial. A great way for investors to build a substantial level of diversification is to invest through mutual funds and exchange-traded funds (ETFs). These funds are made up of bundles of different securities that are invested according to a specific strategy or asset class. Some funds track an index, like the S&P 500. Others are actively managed funds, in which a manager tries to pick the best securities within the fund’s investment mandate. By building your portfolio with mutual funds and ETFs, you will end up investing in hundreds—if not thousands—of individual securities across multiple asset classes. A portfolio that is not diversified may not perform as expected because company-specific risk factors can easily override asset-class considerations. Mutual funds and similarly diversified vehicles, such as ETFs, should be the primary means of implementing your asset allocation strategy in order to avoid this risk.
Do not ignore fees and expenses
Always look for investments with low fees and expenses. Research has shown that funds with average or below-average expense ratios often outperform their peer group. While each asset class is unique, with varying levels of expense ratios, look for funds with below-average fees relative to other funds of the same type. Also avoid funds that charge a front-end or deferred fee, often referred to as “load” funds. Overall, be sure that you understand what you are paying for; if fees are very high, it may make sense to look elsewhere. While fees are not the only factor to consider when evaluating an investment, they should be an important component of the overall evaluation.
Many academic studies have concluded that asset allocation is the most important determinant of a portfolio’s performance – even more so than transaction costs and security selection. The main issue to consider when choosing an asset allocation is your tolerance for risk. While equities provide higher returns over the long term, they cannot be relied upon to provide positive returns over short periods. When you select your asset allocation, you must be comfortable with an allocation’s range of possible returns over not only the long term, but the short term as well. But building your asset allocation is only the first step. Maintaining a substantially diversified portfolio through disciplined rebalancing will ensure your portfolio performs as expected, based on your asset allocation, and that no single company or asset class will ruin your long-term investment results. While there are no guarantees in investing, history has shown that proper diversification and taking a long-term view are the best ways to set your portfolio on a path for success.