Why Portfolio Diversification Is Important

Portfolio diversification is an investment strategy that works to manage risk while capitalizing on gains. Instead of pursuing only aggressive growth (high risk) or decades of incremental gains (low risk), diversified portfolios mix investments to produce a happy medium (at least in theory).

A diversified portfolio doesn’t just seek different companies in the stock market, but different types of investments as well. By picking from various asset types with varying correlations, investors believe that they will yield better returns over a period of years. In fact, several studies have shown that on average, well-diversified portfolios generate more reliable returns than non-diversified portfolios over a period of 25 years or more.

TL;DR

The purpose of diversification is to minimize risk while maximizing reward across your portfolio. There are many ways to diversify a portfolio, such as by:

  • Asset class (stocks, bonds, real estate, etc.)
  • Stock or bond type (high vs low yield, etc.)
  • Market sector (technology vs manufacturing)
  • Market capitalization (the price of a company’s outstanding shares)

It’s also important to diversify your portfolio by correlation, in addition to these metrics. This means that you should spread your capital among securities that move in opposite directions, rather than all together, in order to avoid portfolio-wide losses.

Furthermore, you should consider your risk-reward relationship. For instance, if you measure your portfolio’s risk-reward at 1:5, that means for every $1 you invest, you have a chance to earn $5 in return. It’s important to avoid lopsided or negative risk-reward ratios, which indicate that the risk of investing is far greater than the rewards you’ll reap.

There is no one perfect mix for a portfolio, as every situation is different. It’s advised that investors – especially those new to the market – consult with a financial professional in order to ascertain the best investments for them. However, there are a few steps investors can take to determine their best mix, such as considering:

  • The 5/25 rule
  • Funds that compile several securities into a single slice
  • Individual securities, especially stocks and bonds, with high returns at low risk
  • Adding more stocks for longer time horizons and investing more in bonds for short-term horizons

Regularly rebalancing your portfolio based on market trends, poor or excellent performance, and your personal situation.

Why Diversify?

There are several ways to diversify a portfolio, such as by asset class, sector, market capitalization, and correlation. Usually, investors select a mix of alternatives to diversify their portfolio to the fullest extent. Whatever method they choose, the purpose remains the same: to minimize risk and maximum performance across investments. However, getting too focused on upping your returns can raise risks you weren’t aware were there.

Take our example investor, Investus Prime. He’s new to the stock market and decides that his first big leap is to throw 50% of his investment capital into shares from a single blue chip company, AwesomeTech United. The company’s stock climbs over the course of a year – everything’s looking good!

But then, a deadly biological germ spreads across the globe. Markets panic. Bonds crash. Stocks drop off a cliff. And Investus Prime’s favorite pick, AwesomeTech United, plunges 20% overnight. In one fell swoop, he has lost 10% of his portfolio’s net worth – which means he’ll need to make up more than 10% of his losses to break even (due to the effects of compounding).

Investus Prime could have avoided this unfortunate incident if he had spread his money across multiple stocks. Better yet, he could have put his capital to work in a variety of asset classes with minimal correlations to achieve a better mix. While his portfolio still would have taken a hit, it likely would have suffered less overall.

Before we dive into the right mix of diversification in a portfolio, let’s cover the different ways an investor can spread their risk across the market.

Types of Diversification

As we mentioned above, there are several ways to diversify your portfolio, and no right way is inherently right or wrong. We’re going to cover a couple of the common, “concrete” diversification tactics before we cover the more mathematical side of portfolio diversity.

By Asset Class

When people talk diversification, one of the first things that springs to mind is not putting all of your money in stocks. While diversification is actually a lot more complex than that, diversifying across asset classes is a really good place to start.

In investing, the main asset classes include:

  • Cash and equivalent: Treasury Bills, CDs, money market securities, etc.
  • Stocks (equities): shares purchased from a publicly traded company
  • Bonds: fixed-income securities (IOUs)
  • ETFs: a “basket” of securities from a specific index, sector, etc.
  • Real estate: buildings, land, water and mineral deposits, agriculture, and livestock
  • Commodities: goods that produce other goods or services

Many who subscribe to diversification divide their portfolio by what percentage of their portfolio each asset class will make up first. Depending on which asset classes an investor chooses, they may have more or less ways to split their investments further.

By Stock or Bond Type

Depending on what types of securities you purchase, there are several ways to diversify investments. For instance, an investor who focuses on stocks may decide to split investments 50/50: half in dividend-paying stocks, half in aggressive growth stocks. Alternatively, a different investor may select to invest 50% of their stock portfolio in blue chip companies, with the other half reserved for startups.

Investors who put money into bonds have a vast array of options, as well. In addition to choosing bonds by issuer (company versus federal government, etc.), it’s possible to choose bonds by whether they pay interest or have other mitigating factors. For example, a bond investor can choose to put their money into:

  • U.S. Treasury bonds
  • TIPS (Treasury bonds that pay interest and adjust for inflation)
  • State and municipal bonds
  • Investment-grade corporate bonds
  • High- or low-yield corporate bonds

By Sector

Another way to diversify a portfolio is to spread investments across several sectors. For instance, some investors like to rely heavily on the aggressive growth of the technology industry to bolster their profits. However, this industry can be incredibly volatile, so moving some capital into other industries, such as manufacturing or healthcare, could be a wise decision.

One of the benefits of diversifying across sectors is that this can be done with almost any type of investment. Those who prefer stocks can select from any publicly traded company that offers stocks; those who like bonds can purchase bonds from any company that issues bonds, etc. Sector diversification is even possible in real estate, where investors can choose the type of real estate they prefer – housing, healthcare facilities, factories, etc.

By Market Capitalization

Market capitalization, or market cap, is how much a company is worth in terms of outstanding stocks. In other words, market cap is how much the company would have to pay in order to purchase all of its stock back from its shareholders.

Investors who diversify according to market cap have three basic “types” to choose from:

  • Small cap companies, generally defined as a market cap between $300 million and $2 billion
  • Midcap companies, generally defined as a market cap between $2 billion and $10 billion
  • Large cap companies (also called big cap), generally defined as a market cap above $10 billion

While each market cap comes with its own potential risks, a well-diversified portfolio will take advantage of all the benefits from each to offset these risks.

Diversification by Correlation and Risk

We promised there would be math involved, and we like to keep our promises. While the above factors are good to keep in mind, at the end of the day diversifying across asset classes and market caps means nothing if you don’t account for correlation and risk in your portfolio.

Correlation Between Securities

Let’s bring Investus Prime back for another example. He’s learned from his previous mistake and has reduced his stake in AwesomeTech United to 5% of his portfolio. He has also invested another 5% into an established technology company: Macrosoft Inc. Over time, he notices that every time AwesomeTech’s stock increases, so does Macrosoft; and when Macrosoft goes down, AwesomeTech goes down with it.

This is called a positive linear relationship, simply termed correlation. This financial metric is measured from -1 to +1. Any security pair that falls within this range is said to have a normalized correlation, be it positive or negative.

For instance, if AwesomeTech and Macrosoft have a positive correlation of 0.9, there is a strong correlation between the two stocks. Therefore, when one stock moves in the market, we can expect the other to follow suit most of the time. This correlation means that buying both securities, even in different amounts, introduces a similar type of risk into your portfolio.

In the case of Investus Prime, it’s the same as putting 10% of his portfolio back into AwesomeTech United, even though he purchased stocks in two different companies, since the stocks are going to move the same way at the same time.

Risk-Reward Relationships

Risk-reward is another incredibly important factor in portfolio diversification. It’s worth noting that there is no one uniform way to measure risk-reward, so we’re going to focus on one: return against risk. This is perhaps the most common way that investors think about risk when they begin to invest, as minimizing risk while maximizing rewards is the name of the proverbial game.

The essential risk-reward ratio compares the dollar amount earned against the risk of the investment. So, say Investus Prime calculates his risk-reward ratio for AwesomeTech United as 1:10. This means he risks $1 for the chance to earn $10 in return. But if Investus Prime discovers that his risk-reward ratio actually comes out to 10:1, he risks $10 in order to earn $1 in return.

Risk-reward relationships are frequently used when it comes to investing in the stock market. It’s relatively easy (mathematically) to measure the risk-reward relationship of a single security. Ideally, an investor should seek to have a risk-reward ratio above 1.0 per security. This means that every investment has a greater chance of producing rewards than losing capital.

However, it’s also important to keep in mind that your overall portfolio return can override an individual risk, or even risk as a whole, when correctly diversified.

What Is the Perfect Mix for Portfolio Diversification?

There is no perfect, one-size-fits-all mix of investments for every portfolio. There are dozens of factors to account for, such as financial risk tolerance, emotional risk tolerance, current market performance, etc. This means that every individual will have to decide what the best diversification strategy and mix is for themselves. (Or with the help of a trusted financial advisor.)

That said, regardless of what type of investor you are, there are tips to know about portfolio diversification. These can’t tell you exactly which securities to buy. But they can point you in the right direction for your situation.

Quick Tips

  • Look to the 5/25 rule. An investor should invest in no more than 5 asset classes at once and allocate no more than 25% of the whole portfolio to any one asset class.
  • Consider mutual funds, ETFs, and asset allocation funds. These funds stack a bunch of securities on top of each other. And they let you purchase a “slice,” so to speak. Meaning you gain partial ownership in several different securities at once. This reduces your risk from the get-go and lets you take part in a fund that is managed for you.
  • If you choose not to purchase any of these funds, you can still use their security makeup as a starting point when determining which stocks, bonds, etc. to add to your portfolio.
  • Customize your portfolio with individual securities. This is especially useful advice if you primarily invest in ETFs and mutual funds. By sprinkling in a few single securities, you diversify your portfolio further and experiment with your risk-reward ratio.
  • The longer your investment horizon, the more portfolio room you should dedicate to non-correlated stocks. It’s important to keep in mind your age and risk tolerance when investing in any security. But, if you have a particularly long-term time horizon (more than 20 years), investing more in stocks will lead to higher yields over time.
  • Rebalance your portfolio regularly. Whether you hire an advisor or invest on your own, make sure that every few months you scrutinize your portfolio. Remove securities that chronically underperform or carry too high of a risk. This also gives you a chance to invest in new securities without throwing in a bunch of fresh capital. Just reallocate the capital already floating around in the market.

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