What is Portfolio Diversification?
Portfolio diversification is an investment strategy that involves purchasing a variety of uncorrelated investments to reduce the amount of risk in your portfolio due to price fluctuations.
Investors tend to look for investments that ultimately provide the greatest return, but this involves risky behavior. The significance of a well-diversified portfolio is to protect your investments during inevitable market downturns.
There are hundreds of various assets that can be purchased as investments. A great thing about Wall Street is that they have made investing, even for beginners, relatively easy and without high costs. So don’t be worried that there are so many different investable assets. Most of them aren’t part of the average investor’s portfolio.
The idea behind uncorrelated is that when the price of one asset increases or decreases in value, it does not directly impact another asset in a significant way.
For example, if you invested in Disney (DIS) and Netflix (NFLX) to have exposure to media and entertainment, these would fall into the same bucket. This describes the concept of a correlated investment. The reason is that both could be affected similarly if a competitor were to take a share of the entertainment or media industries.
An investment in Disney and JPMorgan Chase Bank (JPM) would qualify as uncorrelated. Disney is in the entertainment and media industry, and JP Morgan Chase is in finance.
Keep in mind that any two US stocks will have some degree of correlation. Therefore, when choosing a portfolio, it does not necessarily mean that the two assets must have 0 correlation; rather, the correlation should be minimal to a degree.
To take this a step further. An investment in Disney and HSBC Holdings (HSBC), the leading financial institution in Europe, would be further uncorrelated than two US stocks.
Table of Contents
Examples of Diversified Portfolios
Here are some examples of portfolios that are commonly referred to. Of course, each and every investor has their own financial needs and timeline, but this is a good starting point to understand how simple portfolio allocation can be.
Investing for Your Future: Choosing the Right Investments Based on Time Horizon
There is only one factor you should consider when choosing assets for your diversified portfolio.
In how much time do you expect to need the money?
Knowing when you expect to need your money is one of the fundamental questions that you should always be asking yourself. Your plans for selling your investments may change as time goes on, and that’s okay. The markets have a history of ups and downs that you need to plan for, and having a plan will help you maximize your gains for the time in which you expect to sell it. You don’t want your investments in a hole at the time you plan to sell them.
Don’t forget the reason you’re investing your money in the first place. You want to use the money at some point for a purpose, right? Most investors plan for retirement, but numerous other reasons exist for selling investments. Identifying the time you will need the money is essential in choosing which assets are in your portfolio. A person aged 55 will invest much differently than a person aged 30.
For example, if you are age 30 and plan to continue investing until 70, you have much more time and can afford to take more risks. At age 30, you have not hit your prime earning years, so you have a lot more investing to do. In addition, if there is an extended downturn in the market, you will have ample time for your portfolio to recover.
A person age 55 that is planning to retire in 10 years cannot take such risks with their investments. As time gets closer to your estimated time of needing the money, your investments should become more conservative.
A younger person would choose a portfolio with a large weight in stocks. In contrast, someone closing in on their desired withdrawal period will begin converting stocks into more conservative assets such as bonds.
ETFs vs. Individual Stocks for a Diversified Portfolio
For most investors, low-cost ETFs are the best way to build a diversified portfolio. ETFs that track indexes such as the S&P 500 or specific sectors are inherently diversified.
How ETF Diversification Works
Let’s say you want to invest in semiconductors but don’t know which semiconductor company is the best. You have 2 options.
- You choose a handful of different semiconductor companies you think would be great investments and purchase them.
- You buy an ETF such as iShares Semiconductor ETF (SOXX) that holds a portfolio of semiconductor investments with an expense ratio of 0.35%.
A seasoned investor that understands how to analyze companies may choose to research and select a basket of semiconductor companies. Selecting single stocks requires hours of research and analysis to determine which companies to buy and at what price. In addition to the research, it will require more time in the future to monitor and rebalance your portfolio.
The better option for investors who don’t want to spend time researching companies is to choose low-cost ETFs.
Most ETFs will be weighted (hold the largest amount) of the best companies from the chosen sector or index. In addition, they will also hold many other smaller and more speculative companies, but in minimal amounts. SOXX, for example, currently has 35 stocks in the ETF. Holding 35 stocks in a single sector provides excellent diversification within the chosen asset group. Best of all, it will require minimal effort when it comes time to balance your portfolio.
Either strategy can work great. It boils down to the time you want to spend on research and portfolio management. Stock picking may suit you well if you wish to invest your time in understanding financials and researching companies. However, choosing a diversified basket of ETFs is a viable strategy for those who want to invest without meticulous research.
Note: One recommendation is to avoid target date funds. Target date funds are ETFs or mutual funds that are ‘marketed’ as a fund with a future date, implying that the fund will best suit an investor looking to invest until that target date. They use names like “Portfolio 2030, Retirement Fund 2050, or Target 2040. A beginner investor may think they can buy a find like this to accomplish their investment goal for their target date. Target date funds typically underperform, have higher costs, and don’t have the diversification you can create. Take the time and learn what you’re buying.
The Role of Bonds in a Diversified Portfolio
High-grade bonds provide a portfolio with a very-low risk asset that provides a steady yield. Bonds are considered fixed-income asset and typically take the back seat in popularity because of the low yield. But don’t let that fool you.
During economic downturns, when the stock markets are declining, bonds can provide a steady return on your money with minimal risk. Even if the returns are small, it is far better than losing value. Moreover, these returns will usually be better than what a bank account would return. Thus, they are still better than holding onto cash.
Choosing high-grade bonds or even government-issued bonds can minimize the risks associated with bonds.
Navigating Economic Conditions: With the Use of Diversification
Economic conditions are often changing and might be difficult for the average investor to keep up with. The sole purpose of a well-diversified portfolio is to minimize the impact on your portfolio during rough patches in the economy. Investors should expect and anticipate these conditions and remain confident in their long-term goals.
Declining markets can offer some of the most significant investment opportunities. Many of the greatest investors, such as Warren Buffett, use these periods as buying opportunities. Utilizing a dollar-cost averaging approach and continuing your investment strategy during these down markets can provide significant value to your portfolio over the long term.
Here’s a famous quote from Warren Buffett for you to remember during various economic conditions: “be greedy when others are fearful, and fearful when others are greedy.”
Incorporating Collectibles into Your Diversified Portfolio
High-end collectibles can be a great addition to your portfolio, especially when it involves a passion or a hobby. The most popular collectibles include art, sports cards, memorabilia of all types, stamps, and vintage cars, among others. Some collectibles, such as sports cards, have a history of well over 100 years and a track record of the price that outperforms the S&P 500.
Collectibles are considered extremely risky from an investment standpoint. As with any high-risk asset, an abundance of caution should be taken. If collectibles are chosen as an asset in your portfolio, they should only comprise a small percentage of your overall portfolio.
Those that wish to have collectibles as part of their investment portfolio should only do so if the collectible is part of a deep passion or hobby. Possessing a great understanding and having an insider’s perspective can provide the necessary insights into making wise investment decisions. Without the specific knowledge of the collectible, you would simply be gambling on someone else’s advice. Even with the background knowledge, the risks associated with collectibles are typically much higher than those of securities, such as stocks or bonds.
*The finance world uses the word alternative assets to describe commodities, real estate, private equity, venture capital, and hedge funds.
Understanding Different Types of Risk and the Role of Diversification
Investing involves numerous risks, and a continuous risk-versus-reward analysis should always be considered closely. Of course, the natural way of thinking is to focus on the reward, but this is not a thoughtful approach. The most brilliant investor will continuously evaluate the risks and the rewards and make investment decisions based on both criteria.
Minimizing risk is the most critical aspect of investing – and the fundamental idea of diversification. But you should not be so much on the defensive that you cannot generate returns. Learning about the potential risks involved with any chosen assets in your portfolio provides information that can help you develop a portfolio that can minimize potential risks and supplement those risks with other asset types.
Drawdowns (loss of value) in a portfolio are an inevitable part of the investing process. Determining which factors may put your portfolio at risk puts you on the defensive side of protecting your portfolio.
The two primary forms of risks are market risks and specific risks.
Market risk refers to the overall performance of the financial market. Market risks are the hardest to avoid because they typically affect most assets when they do occur. Sources of market risks include changes in interest rates, geopolitical disputes, natural disasters, and recessions, among others.
Specific risks are related to a specific industry, sector, company, or a particular asset class. A wide variety of risks can be associated with any individual asset. For example, a company could depend on a specific technology patent for its revenue sources. Another company could jeopardize this patent with either an improved technology or a lawsuit over the existing patent.
Specific risks exist for every asset in your portfolio. Understanding what these risks are and using them as a framework to diversify your portfolio is an ideal approach to diversification.
Best Practices for Reviewing and Adjusting Your Investments
Most investors only need to review their portfolio 2-4 times a year. Investors that have chosen ETFs as their primary investment vehicles will have far less work to do than those who select individual stocks.
Individual stock pickers need to pay attention to the earnings reports for each company every quarter. All publicly traded companies report earnings on a quarterly basis (four times per year). These events are typically the times in which those stock prices fluctuate the most. Investors are provided with the company’s financials and other necessary information to make financial decisions about a company.
If your portfolio is made up entirely of ETFs, then the review process and rebalancing are straightforward.
Take the time to review each of your investments as a percentage of your overall portfolio. Then, match the percentages to your original desired portfolio allocations to identify any assets that have become over or underweight. If your portfolio percentage allocations have become out of balance, then it’s time to rebalance.
Rebalancing means selling some assets with a higher than desired percentage allocation in your portfolio and buying assets that are lower than the desired percentage allocation.
For example, if your desired portfolio is 80% Stocks and 20% bonds and has shifted to 70% stocks and 30% bonds. You would then sell the bonds to achieve your 20% allocation and use the proceeds to purchase stocks back to 80%. This is portfolio rebalancing.
Following this simple idea of rebalancing your portfolio consistently over the long term can provide significant value to the result of your investments.
Building a Diversified Portfolio: Exploring the Different Types of Assets to Consider
There are a vast amount of assets that you can choose to invest in. Here is a list of the most common investable asset classes:
Cash and Cash Equivalents
-No risk, no return (inflation)
Equities (Stocks)
-High-risk, high reward
-Most stocks are highly liquid and have little transaction costs in comparison to other assets.
-Subclasses: sector, industry, value, growth, large-cap, mid-cap, small-cap, countries
Fixed Income (Bonds)
-Low risk, low returns (bondholders get paid before shareholders)
-Returns consist of capital gains (bond price growth – if bought below par) and income (coupon payments)
-Sensitive to interest rates (and thereby monetary policy, inflation, and economic cycle)
-Also sensitive to issuer’s ability to repay = credit risk (and thereby to economic cycle)
-Subclasses: maturity date, credit rating, fixed rate, floating rate, government, corporate, emerging markets
Commodities (metals, oil, agriculture, energy)
-Higher risk, lower return than equities
-Storage costs and convenience yield – if holding physical commodities
-Liquidity varies – oil, gold, and silver are the most liquid. Even some ETFs are not very liquid.
-Subclasses: energy, agriculture, industrial metals, precious metals
Real Estate
-Lower risk, lower reward versus stocks – in most cases.
-High transaction cost, low liquidity
-Maintenance costs
-Subclasses: land, residential, commercial
Private Equity
-Very high risk, high reward
-Very low liquidity
-For most investors, this is venture capital
Hedge Funds
-Moderate risk, moderate reward.
-Lower liquidity – many have lockup periods and early withdrawal penalties.
-High management fees
-Subclasses: equity directional (long only, long/short), corporate restructuring, relative value, macro, quant
Alternatives
-High-risk, high reward
-Highly specialized areas (must have unique knowledge of the area)
-Low liquidity
-Subclasses: artwork, classic cars, stamps, antiques, books, sports cards, cryptocurrency, NFTs, collectibles, comics, memorabilia, wine & spirits.
Insurance
-The main role is risk management
-Payoff subject to specific conditions
-Subclass: life insurance, whole life insurance
Conclusion
Every investor will have different needs, circumstances, time horizons, and risk tolerance. Constructing your portfolio is based on your own set of needs. Think about your situation, and learn how to properly organize your investments to fulfill your investment goals. It does not need to be overly complex if you do not wish to.
Beginner investors can do well with a simple portfolio of several ETFs. Then, over time, your portfolio can be modified to meet your changing goals and investment ideas.
The objective of diversification is to protect your portfolio during times of an economic downturn.
:: Pop Quiz ::
1) True or False: Diversification protects an investor from any losses in their portfolio.
2) True or False: Diversification is only important for long-term investors.
3) True or False: Investing in a variety of stocks within a single industry provides adequate diversification.
4) True or False: Bonds can provide stability to a diversified portfolio during times of market volatility.
5) True or False: Investors should adjust their portfolio as their time horizon changes over time.
See below for the answers.
1) False. While diversification can reduce risk, it cannot completely protect an investor from losses. All investments come with some degree of risk.
2) False. Diversification is important for investors of all time horizons, as it can help to reduce risk and protect investments.
3) False. Investing in a single industry, even with a variety of stocks, does not provide adequate diversification as the stocks may all be subject to the same economic and market factors.
4) True. Bonds are generally less volatile than stocks and other assets, and they can provide stability to a portfolio during times of market volatility. During a market downturn, investors may move out of riskier assets like stocks and into safer assets like bonds. This can help to stabilize the portfolio and potentially reduce losses.
5) True. As an investor’s time horizon changes, their investment goals and risk tolerance may also change. For example, a young investor with a long time horizon may have a higher risk tolerance and be willing to invest more aggressively, while an older investor with a shorter time horizon may have a lower risk tolerance and be more focused on preserving capital. As a result, it is important for investors to periodically evaluate their portfolio and adjust their investments as needed to ensure that they are aligned with their investment goals and time horizon.