The old saying “don’t put all of your eggs in one basket” is simple, yet sage advice for all investors. Drop the basket and all eggs are broken. Put all your money in one company or stock, and it can financially devastating if it falls.
Diversification is an important aspect of investment portfolios for a variety of reasons. Certainly, reducing risk is one of the big benefits. Spreading investment capital over multiple investments helps to minimize risk of loss. Diversification also helps to reduce volatility and create stable performance within investment portfolios.
Even when the Dow Jones Index – a key benchmark for the U.S. stock market – jumps 200 basis points in a day, it doesn’t mean that all stocks rise, or that all stocks rise equally. Stocks such as Apple, might increase $5 a share, while Tesla drops $25 per share. Likewise, different types of investments react very differently to the same market events. For example, publicly traded stocks can be more reactive to market news, such as the latest jobs report or even a controversial political “tweet”. In comparison, fixed assets such as bonds or private equity real estate investments, have stable values that are less reactionary.
Diversification also helps to achieve different investment goals. In some cases, different types of assets serve different purposes or fulfill different needs. For example, some investments are growth oriented with an emphasis on value appreciation, while others generate income or cash flow.
How do I build portfolio diversification?
Creating portfolio diversification is simply a matter of spreading capital across multiple investments. It sounds easy. However, it is important to recognize the different ways to achieve diversification across portfolios, as well as the potential concentration risks that might be lurking under the surface.
For example, an investor who owns stock in 20 different companies has, theoretically, created diversification. However, there is zero diversification in asset type if all of those holdings are in the stock market. Additionally, if all of those stocks are invested in one industry, such as technology, there is no diversification related to risks that could negatively impact performance within that one sector.
There are many ways to achieve portfolio diversification in order to avoid concentration risk in similar investments. Some examples to consider include diversifying across:
- Asset type: Some common investment products are stocks, bonds and mutual funds, as well as direct investment in tangible assets, such as real estate, timber, oil, art or gold. For example, private equity investment in real estate assets can be a great way to diversify broader investment portfolios. Real estate often moves counter to other assets and is not subject to wild swings in values that are all too common in the stock market these days.
- Business or industry: There are plenty of examples of business sectors that have experienced “bubbles” or boom and bust cycles, such as the housing market, oil & gas and tech to name a few. Investing across sectors helps to insulate portfolios from the ebbs and flows that naturally occur within sectors.
- Risk Level: Diversification also applies to the risk or perceived risk level of specific investments. The risk profile can range across a spectrum from zero risk (government-backed bonds or certificates of deposit) all the way up to extremely high-risk ventures where there is a chance an investor could lose all of the original capital invested. It is important for investors to understand their overall risk tolerance, and also look at how the overall risk within a portfolio fits within the context of their accepted risk tolerance.
- Geographic: Different countries, regions and even local cities can be subject to their own economic cycles of accelerating, flat or even declining growth. Additionally, regions also may be subject to unique locational factors, such as the risk of business disruption due to seasonal flooding, hurricanes or other extreme weather events. So, it is important to consider diversifying holdings to avoid certain geographic concentrations.
What’s the right formula for diversification?
There is no single answer or perfect formula to create an optimal diversified portfolio. For most investors, diversification is an ongoing process that continues to evolve over time. Portfolios and asset allocations need to be adjusted as investments are bought, sold or investing goals and objectives change. The best advice is to work with an experienced advisor to manage portfolios that match your tolerance for risk and your investment goals and objectives. As with any investment and financial planning strategy, it is always wise for investors to conduct careful due diligence and work with a trusted advisor.