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October 20, 2020

Diversifying your portfolio 101

Diversification seems illogical in times to market booms: why would someone willingly buy something of less value when you could spend the same amount of money on the proven winners? It goes against everything we’re taught in school and in life by society. This concept of diversification – knowingly buying a security that isn’t the ‘winner’ – is not only flawed, but often harmful.

Diversification is an investment strategy that blends different asset types in a single portfolio. The wisdom behind this lies in the idiom, “don’t put all your eggs in one basket.” There are two main reasons that diversification is a cornerstone of any investment portfolio:

  1. A variety of investments will yield a higher return over time
  2. The overall risk exposure of the portfolio will be lessened through market ups and downs

Traditionally, there are 4 primary components of a diversified portfolio. With the rise of alternative assets like cryptocurrency, crowdfunding, and angel investing, investors today have a few more options. Basic concepts, however, remain the same. The components are:

Here’s what you need to know about diversification and introducing it into your portfolio:

Diversification is not a theory, it is a proven strategy

The true value of diversification shines in market depressions. Although many portfolios and investments lost value during the Great Recession in 2008-2009, diversification helped contain the losses.

Looking at the example below from Fidelity, it’s clear that out of three options: a diversified portfolio of 70% stocks, 25% bonds, and 5% short-term investments; an all-stock portfolio; and an all-cash portfolio most people would have been better off with the diversified portfolio option.

Overall, the diversified portfolio lost less than an all-stock portfolio in the downturn. On the upturn, it did take a bit longer for the diversified portfolio to recover, but over time it captured much of the market’s gains. If you’re doing the right thing for your portfolio and investing long term, you would manage risk while still maintaining exposure to market gains using a diversified portfolio.

Diversification works better if you do it regularly

We’d all love a windfall – a bonus, inheritance, or (arguably) a tax refund – to maximize our first deep dive into investing. But the truth is, the biggest benefits in investment come from investing money regularly and consistently.

Consider allocating a percentage of your paycheck to investments so that it’s not taking up important decision-making capacity in your life. When you invest regularly, you’ll even out the risk of buying when prices are high or selling when prices are low. This is called dollar cost averaging but is essentially a diversification across time.

Diversification and rebalancing go hand in hand

As asset prices rise and fall, your portfolio allocation based on a $$ value might change. Let’s say you started out with a 60/40 split between stocks and bonds. This is your ideal diversification and makes sense for your life and finances. Say you happened to own a superstar stock that had a record-breaking year. The stock shot up in value more than anyone expected. At the end of the year, your portfolio would no longer be a 60/40 split between stocks and bonds. In order to maintain your ideal mix and remain diversified, you would have to rebalance your portfolio. Robo-advisors and money managers do this automatically, but basically this means selling some assets to purchase more of others that help meet your diversification targets.

To rebalance and diversify, you truly need a concrete understanding of your long-term goals. Your investments should fit your life and work for you, not the other way around.

Owning a variety of stocks is no longer enough

This year is an example of how interconnected our economy – and by extension the stock market – is. Changes in employment, technology trends, global relations, global health all impact the market as a whole. This is why it’s no longer enough to own a variety of stocks.

Consider other asset types that are readily available like bonds, cash or cash equivalents, ETFs, or options. Each of these has varying characteristics and benefits, such as differing risk/reward profiles, costs, and time horizons that can help manage your overall risk. Some are correlated with others (like individual stocks and ETFs sometimes), which can make it a bit more complicated to completely diversify.

You can diversify in even more ways than asset types. For example, think about the industries and sectors you are exposed to. Does tech make up a huge part of your portfolio? Different asset types and industries perform at different paces a lot of the time. Some asset types and industries move together, others are direct opposites. These relationships change infrequently, but they do change. For example, precious metals like gold moved conversely to the stock market for much of the previous decade.

There are a lot of resources out there to help you diversify

Technology is a wonderful thing when it comes to investing and diversifying. Take advantage of it all -401(k) plan management tools, robo-advisors, online trading platforms, crowdfunding sites, real estate investments, small business lending, crypto-trading, and so much more. Use these tools to see how your portfolio could benefit from an extra 5% in real estate, or if your diversification mix is ideal for your risk tolerance.

Doing this manually can be time consuming and discouraging, so don’t be afraid to use online resources and technology to help you achieve an ideal investment mix.

Diversification isn’t just limited to your portfolio

Think about all the other areas of your finances you can apply this concept to. If you have shares of the company you’re employed by, it might be time to step out of your comfort zone. Not only is a big chunk of your portfolio tied to the performance of your employer, but your job, bonus, and resume is too. If the company is struggling, you might suffer a larger than proportionate financial hit.

Is there anything diversification can’t do?

Beware of any one-solution-fits-all advice regarding investment. Diversification, while an important tool, does not guarantee better returns or fewer losses. It’s simply a technique that can help you reach your long-term financial goals.

The bottom line

Investing is a long-term balance between risk and reward. Diversification helps anyone from the average investor to large institutions choose the right mix of asset types, sectors, and risk profiles. That, combined with periodic rebalancing and a mindful approach to new investments, can make a huge difference in investment outcomes.

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