Finding a successful balance between growth potential and assumed risk can be tricky. One strategy to mitigate risk is diversification. Today, we will discuss how investors diversify their holdings, as well as why they do it.
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What is Diversification? Why Do Investors Diversify?
When you diversify, you place your money in a variety of separate investment vehicles. By splitting your funds between a group of investment options, you can hopefully reduce your exposure to market volatility while also reducing your risk level.
While most investors hope that every investment they make is profitable, it’s likely that at some point some investments will not generate a return or will even lose money. Diversification helps keep an investors aloft during these times, since one failing investment can potentially be balanced out by the other more successful investments in the portfolio. For instance, if you hold stock in multiple companies instead of a single one, your risk of losing a lot of money if that single company goes down is reduced.
How Do Investors Diversify Their Portfolio?
There are a number of ways investors diversify their portfolio. Most diversification strategies are based on the essential premise that diversification is expected to reduce risk and therefore improve returns (keeping in mind that all investing bears risk of loss). These strategies include maintaining a certain asset allocation, buying a variety of funds, and diversifying within asset classes. Let’s take a closer look at each:
Consider Investments with Different Risk Levels and Time Periods
Since diversification is all about reducing risk exposure, many investors look to diversify by holding investments with differing risk levels. The risk levels an investor chooses are dependent on how comfortable they are with risk, but many choose to balance out more secure investments like blue-chip stocks with more risky investments like small-cap and mid-cap stocks.
Additionally, many investors choose to have investments with a mix of long-term, medium-term, and short-term outlooks, even if their time horizon is fairly long. By having differently timed investments, the aim is to couple a relatively more secure investment like a short-term money market fund with a longer-term asset like a mutual fund in order to provide liquidity while also prioritizing steady growth.
Diversifying by Asset Allocation
Most investors focus on asset allocation as a first step to diversifying their holdings. Simply put, asset allocation involves investing in numerous different types of assets to ensure the portfolio is not too heavily weighted towards only one or two asset classes. For instance, an investor may choose to divide their portfolio between 40% bonds, 25% foreign and 35% domestic stock if they would like a somewhat balanced portfolio. A more aggressive investor might reduce the amount of bonds and increase the amount of stocks instead.
There are a number of different assets an investor can choose to put their money into, including index funds, ETFs, mutual funds, stocks, bonds, and short-term investment vehicles like short-term certificates of deposit and money market funds. A well-diversified portfolio may include all of these to some degree, depending on the investor’s overall goals.
Diversifying Within Asset Classes
While asset allocation is important to help diversify a portfolio, many investors choose to supplement it by diversifying their holdings within each asset class.
For example, investors may choose a variety of different stocks, both domestic and foreign, across a range of sectors and industries. Many investors have invested heavily in a specific company or industry, such as the financial or industrial sectors, and ended up taking large losses because the entire industry or sector took a significant downturn. To help avoid this possibility, many investors make sure their holdings are not too similarly situated even within the same asset class.
Rebalancing Your Portfolio Periodically
When investors set a certain risk level they want to keep their portfolio at, they might want to maintain that level by regularly rebalancing their portfolio. The aim is to keep the portfolio in generally the same proportion over time in order to maintain a similar risk level by balancing out the growth in certain asset classes with the losses in others.
For example, suppose an investor wants their portfolio split between 40% US stock, 30% US bonds, and 30% foreign stock. After a year value changes in these investments, the portfolio changes to 50% US stock, 30% bonds, and 20% foreign stock. To rebalance, the investor would sell off some of their US stock and buy more foreign stock until they reach the 40/30/30 split again.
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Disclosure
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investing involves risk including loss of principal. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk. Rebalancing a portfolio may cause investors to incur tax liabilities and/or transaction costs and does not assure a profit or protect against a loss.
