Diversification is an essential strategy that investors use to protect their portfolio. Diversification gives successful investors the discipline to stick with a plan that moves them toward their goals and the courage to change a plan that is not working.
The purpose of this article is to help you understand what a diversified investment portfolio is and why it’s important for whatever stage of life you’re in. We’ll also give you some simple strategies for creating or rebalancing your portfolio with an eye towards diversification.
What is a diversified investment portfolio?
A diversified portfolio is about asset allocation. A diversified portfolio should take into account:
- An individual investor’s tolerance for risk
- Their investment goal(s)
- Their timeline for reaching those goals
To illustrate what a diversified portfolio looks like, think back to the food pyramid you learned about in elementary school. The food pyramid reminds us of the importance of a balanced (or diverse) diet. The takeaway is that different foods provide different benefits to our bodies. The common sense lesson is that consuming too much of one group at the expense of another may lead to short- or long-term health problems.
It’s the same way with investing. Diversification is about making conscious, purposeful decisions to divide your investment dollars among a variety of asset classes. Failing to do so can have a negative impact on your investments.
There are several components (or groups) of asset classes. Each of these plays a specific role in an investor’s portfolio. For the purposes of this article, we’re going to focus on a core portfolio that should consist of a mixture between:
Cash (CD’s; money market funds)
NOTE: There are certainly other investment types including precious metals, real estate, and currencies (even cryptocurrencies) to name a few. They are not meant to be avoided completely. In fact, they can offer tremendous growth opportunities. As you consider them in your portfolio, you should view them on the “most aggressive” end of the table and allocate money accordingly.
The thing to remember about a diversified portfolio is that you are deliberately combining assets that will move in different directions. When the economy is doing well, stocks tend to rise because they become attractive to investors who are looking for a higher rate of return and are optimistic about a company’s prospects. Conversely, bonds tend to perform better when the economy is doing poorly because investors are seeking less risk and view bonds as a safe haven. The goal of diversification is to position your money so that no matter what the economy is doing at a given point, your overall portfolio is being protected because at least one asset class is growing.
However, diversification goes beyond just dividing your assets between stocks, bonds, and cash. Even within each investment type, diversification is important. Going back to our food pyramid example, if you eat steak one day, brisket the next, and burgers after that, you are having a really good vacation. However, if you do that over a period of months, or years, you’ll find yourself in front of a cardiologist who will point out that red meat by another name is still red meat. To get diversity in your diet, you not only need to add other proteins (i.e. diversity within the food group), but you need to ensure that the other food groups are present as well.
It’s the same when you invest. If you decide to put 75% of your portfolio into stocks, but then buy only “tech stocks”, that’s not diversification. If the tech sector goes through a correction that the entire 75% of your portfolio is at risk. And keep in mind that even if one sector of stocks are correcting; other sectors can continue to perform well. Utility stocks are a good example of this. They will never be the shining stars of a bull market, but when the economy is in a recession, these stocks can be reliable performers. Diversification is about owning assets in a variety of sectors to help even out the ups and downs that come from individual sectors.
To sum it up: A diverse investment portfolio is about ensuring that you have an appropriate mix of stocks, bonds, and cash to meet your goals.
Why do I want a diversified portfolio?
Almost without fail, risk management is brought up as the primary benefit of diversification. And it’s true that diversification is fundamentally about managing risk. But a different way to think about it is this:
A diversified portfolio helps you optimize your growth by managing your risk.
We’d all like to think of ourselves as savvy investors. We all want to buy the next Amazon or Google for a few pennies per share and then just sit back and watch our portfolio grow and grow. However, you know that investing doesn’t work like that. In fact, investments tend to follow Newton’s third law of motion: For every action, there is an equal and opposite reaction. Markets go up and down, and sometimes they can swing wildly in opposite directions on the same day. When they do, you need a plan to balance out your winners and your losers. When you do this, over time, your investments will continue to grow, independent of what the market is doing.
Another benefit of diversification is that it forces you to set priorities and allocate your money based on those priorities. Investing can be like riding a roller coaster. For many investors, especially during a bull market, there is a certain thrill in chasing the latest hot thing or riding a new trend. In investing this is called chasing returns. You determine what investments performed well in the last month, quarter, year, etc. and move money to “chase after” those gains. However, as most investors quickly learn, this is a very risky strategy that often leaves them zigging when they should have zagged.
The opposite of the aggressive investor is the investor who wants to avoid all risk. So they keep too much of their portfolio in bonds and cash and miss out on the gains that they can get during bull markets.
In both cases, some of this behavior is human nature. However, many times it’s because these investors have no real plan. And as the saying goes, when you fail to plan, you plan to fail. Creating and maintaining a diversified portfolio requires discipline. Aggressive investors may feel anxious that they’re missing out on returns in a red-hot market. Conservative investors may get nervous when the market is going through a correction. But, in both cases, showing a commitment to diversification is a proven way to help each investor meet their goals.
How do I add diversity to my portfolio?
Now that we’ve explained what a diversified investment portfolio is and why it’s important for you to have one, it’s time to show you how to add diversity to your portfolio. Let's go back to the food pyramid one more time. As nutritionists understand more and more about the human body, the food pyramid has been tweaked to compensate for individual bodies. It's common sense actually. A marathon runner will have different nutritional needs than a construction worker.
It’s the same with your portfolio.
A 30-year old professional who is thinking about starting their own business is going to have different investment needs than a 56-year old empty-nester who wants to retire at 60. The good news is diversification can be applied to an investor’s portfolio at whatever stage of life they’re in.
Because a diverse investment portfolio is a hedge against risk, it is frequently seen as a strategy that investors only need as they face retirement. But diversification is not just about ensuring we don’t outlive our money. It is just as important for the investor who is saving for college, looking to start a business, or save for their child’s wedding.
As we said earlier, a diversification strategy takes into consideration risk tolerance, investment goals and the timeline for reaching those goals. When it comes to choosing how you’re going to achieve diversity, we should add how much time and interest you have to put towards researching your investments.
One way to build a diverse portfolio is to pick individual stocks and bonds. In this information age, information about publicly held companies is as close as your mobile device. You can also use tools such as MarketBeat Daily Premium to get analysts ratings on individual stocks.
However, many investors don’t have the time, or expertise, to research individual stocks. For these investors, mutual funds are an appealing alternative. Mutual funds invest in a variety of stocks, bonds, or commodities. Sometimes, but not always, they will invest in multiple asset classes. In many cases, you can choose a fund that will balance assets to your goals and adjust accordingly.
For investors whose primary goal is saving for retirement, a great mutual fund option is a lifestyle fund. A fund like this is truly a set it and forget it option. These funds automatically adjust the way your assets are allocated based on your age. So, for example, if you have a 30-year window until retirement you can choose a fund that has a target date of 2050. Initially, this fund will be weighted towards stocks. But as time goes on, it will automatically rebalance the asset allocation to the relative safety of bonds so that the gains you’ve made over the years are protected.
Investors who have more sophisticated needs or who want more control over their investments may choose mutual funds that invest in a single asset class such as small, mid or large cap stocks. These funds will be listed as either having growth stocks or value stocks. There are international funds that specialize in both developed and emerging markets. Bonds offer similar opportunities to diversify depending on an individual’s risk tolerance.
However, like our steak and brisket example, an investor has to be careful here to make sure that they are choosing a variety of mutual funds so that they have exposure to both growth and value across a variety of sectors.
Can diversification be too much of a good thing?
If a little diversification is good, is it possible to get too much diversity in your portfolio? The answer is yes, and here’s why. Trying to "micro diversify" gets us into a situation where to use a cliché "we can’t see the forest through the trees”. We focus so much of our attention on diversifying inside one asset class that we forget about others.
A good analogy is a person who’s trying to lose weight and is told to try different exercises. But instead of trying one exercise and taking the time to evaluate the results, they add multiple exercises thinking if one is good, more have to be better. Before long, they’re overwhelmed by all their choices and just go back to what they were doing and accept results that are less than what they want.
Diversification is about finding an investment mix that is working for you. And part of an investment plan working for you is your ability to easily see and understand how your investments are adding to your risk and your reward.
What’s the bottom line?
Will diversification take all the risk out of investing? Certainly not. Even the most informed and disciplined investor will have investments that don’t work out for one reason or another. However, by having a mixture of assets in your portfolio, you give yourself a better chance of minimizing losses and maximizing gains.