If you have spent any time reading about the principles of investing, you have undoubtedly come across the concept of diversification. We are all familiar with the adage of “not putting all your eggs in one basket,” and this holds true for investing as well. There are different kinds of risks involved with investing and diversification is a proven method for reducing the overall risk in your portfolio.
How Diversification Works
A diversified portfolio will have an array of asset classes that react differently to various economic and market conditions. For example, when stock prices are rising bond yields are often falling. A properly diversified portfolio will not be overweight in any one sector or security. This strategy lowers the odds that all or a significant amount of your investments will experience a loss at the same time, while potentially yielding a higher return in the long run.
How Do I Diversify My Portfolio?
The first step in diversifying your portfolio is to determine the appropriate amount of stock and fixed income investments for your portfolio. This will be different for every investor and is determined by considering factors such as the size of your portfolio, your timeline, and risk tolerance. Once you know what this split is, both the stocks and fixed income investments will need to be further diversified. We will look at how to diversify the stock in your portfolio first.
Market Capitalization—
Your portfolio should hold stocks in companies with various market capitalization values. Market cap refers to the size of the company and the general classifications are large-, mid-, and small-cap companies. Large-cap companies are generally older companies that will grow more slowly and are less volatile than mid- and small caps which are more riskier investments.
Growth and Value Stocks—
If you ask investors what is most important to them about their portfolio, you will probably get the answer that growth is the most important factor. This leads many investors to invest heavily in growth-oriented stocks which are defined as companies that are growing faster than other companies in the same industry or market. Value stocks are another class and are defined as stocks that appear to be undervalued based on a review of their fundamentals such as revenue, dividends, and profit margins. What many investors do not realize is that value stocks have historically outperformed growth stocks in the long term. Make sure you are diversifying your portfolio by including both growth and value stocks as well as stocks that do not fall into either of these categories.
Real Assets—
Real assets are a very popular addition to investment portfolios for several reasons. They are hard assets with a low correlation rate to other asset classes. This means that when one market sector may be declining in value, real assets may be increasing in value. They are also a good investment to hedge against inflation, provide income, and provide capital appreciation. As an asset class, real assets are already very diversified since they come in many different types such as commercial, residential, retail, and healthcare real estate. In addition, infrastructure stocks fall into the real asset category and provide exposure to industries that people rely on to live, work, and travel. Some examples of infrastructure are oil and gas pipelines, waste management, shipping and freight, railroads, and engineering.
International Markets—
It is important to incorporate international stocks in your portfolio because they often perform differently than stocks of US-based companies, thus reducing the overall risk in your portfolio. Within the international asset class, consider including some exposure to stocks in emerging markets. These are stocks of companies in developing nations which typically have fast economies and potential for high growth.
Bonds—
On the fixed income side, bonds are the first investment that most people think about and are a great way to increase the diversification in your portfolio. Within this category there are many different types of bonds to choose from so make sure you are incorporating a variety. Types to consider include US investment grade, high-yield, global, and treasury inflation protected securities (TIPS). However, bonds are not the only investments to consider on the fixed income side.
Hybrids and Precious Metal—
There are some investments that do not really fit into the category of stocks or bonds, so we think of them as hybrids. These include convertible bonds which pay interest but can be converted into common stock, and preferred stock which is a stock but pays a fixed dividend. In addition, adding precious metal to your portfolio adds diversification because it has a very low or sometimes negative correlation to stocks.
Implementing Diversification in Your Portfolio
Now that you know how to diversify your portfolio you may be wondering what the best way is to accomplish this. Utilizing mutual funds or exchange-traded funds (ETFs) in your portfolio is the easiest and most efficient way to diversify your portfolio. These funds come in every one of the asset classes discussed above and since they contain a basket of securities they are already diversified. Avoid investing heavily in only a few individual stocks as that will reduce the diversification in your portfolio and increase risk. If you are interested in a particular company, it would be better to invest in an ETF that holds a high percentage of that company instead of directly in that one stock.
Being able to meet your financial goals while not worrying about your portfolio is the happy medium most investors are looking for, and you can accomplish this through the diversification strategy. It smooths out the effects of market volatility on your portfolio and allows you to earn the highest return with the least amount of risk.
Deborah Hobart, CPA is a Financial Advisor at Blue Water Capital Management, LLC, a fee-only financial advisory firm in Apex, NC. For more from Deborah, check out Blue Water’s latest Investing Insights on their website.