Everything You Need To Understand About Portfolio Diversification

Commodities Investing, Diversification, Real Estate Investment Trusts (REITs)
Portfolio diversification: Businessman smiles while typing on his computer

Everyone wants to find the sweet spot between risk and reward. As the saying goes, if there is no risk, there is no reward!

How can you locate that sweet spot when investing? Is it possible to form a strategy geared toward balance? One such strategy can help you keep a stable portfolio: diversification.

Diversification involves spreading your risk across various asset classes and sectors to increase your odds of success. Even though it doesn’t shield you against loss, it helps you reach your financial goals while minimizing risk.

It may sound impossible, like juggling flaming baseballs, but creating a diversified portfolio is easier than you think.

Read on to learn about the types of risk associated with investing and how to add diversification to your portfolio.

The Types of Risk Associated With Your Investment Portfolio

When investing for diversification, remember there are always risks involved. You should be cautious about two different types when you invest: systematic and unsystematic risk.

Systematic Risk

Systematic risk is risk that can’t be controlled by a company and affects the entire market as a whole. Macroeconomic incidents are the main culprit of systematic risk, such as:

  • Inflation
  • Changes in interest rates
  • Currency fluctuations
  • Recessions

While you can’t eliminate systematic risk entirely, you can mitigate it through asset allocation. For instance, owning different asset classes with low correlation can smooth out portfolio instability because each asset class reacts differently to macroeconomic events.

Unsystematic Risk

The opposite side of the spectrum involves unsystematic risk, which consists of a company- or industry-specific risk. This type of risk is uncorrelated with stock market returns.

Types of unsystematic risk include:

  • Liquidity risk
  • Business risk
  • Credit risk
  • Legal risk

Can you reduce unsystematic risk through diversification? The answer is yes!

For example, say your portfolio contains three stocks, all in the same industry. If an adverse event were to hit the industry or company, your portfolio would suffer significant harm. To avoid damage to your portfolio, diversifying with 20-30 investments in different sectors is the best route to take.

That is why diversification is a crucial component of your portfolio selection. You can reduce the risk with individual stocks, but market risk affects every stock. So, it’s also critical to diversify among different asset classes and to spread out your risk over various sectors. While one performs terribly, another may perform nicely.

4 Ways To Diversify Your Portfolio

Market volatility and unpredictability make your investment journey bumpier. Diversification can make it a smoother ride and increase your chances of success. Time and correlation are two critical elements when it comes to portfolio diversification.

First, you need to consider the time frame of your goals. If you have short-term goals, you should invest your money differently than if you have longer-term goals. The longer your investment time horizon, the more your risk tolerance increases.

Second, you need to consider how your investments are correlated. Correlation is the degree to which your investments move simultaneously. For example, when stocks start to drop, bonds tend to do well. If your entire portfolio moves together, you are not diversified.

Timing is everything when constructing a portfolio, and having an uncorrelated portfolio can help you achieve the benefits of diversification. Here are four ways to start diversifying your portfolio.

Vary Your Asset Classes

The most common way to diversify is through an asset allocation strategy that includes a mixture of stocks, bonds, ETFs, real estate, and commodities.

Different types of assets have cash flow streams with varying degrees of risk. By choosing an assortment, you can ensure your portfolio stays diversified. A well-diversified portfolio increases your probability of making an excellent return.

Let’s explore four asset classes you might consider for your portfolio.

Equities

Selecting individual stocks with high growth potential can boost your portfolio’s returns. If your portfolio only contains a single stock, it can provide an excellent return. However, its price would fluctuate more than the broad market. That’s why adding a second or third stock can provide better diversity.

And, you don’t have to restrict yourself to individual stocks. ETFs and mutual funds can also help you with diversification.

An exchange-traded fund consists of a collection of securities, such as stocks that track an index. Choosing an ETF over individual stocks grants you instant diversification. An ETF can consist of hundreds to thousands of stocks. When you buy one share of an index, you own every stock in that index.

Mutual funds also offer diversification benefits.

Fixed Income

Many investors still follow the old 60/40 rule. This rule states that 60% of your portfolio should be made up of stocks, while the other 40% should consist of bonds.

During heavy inflation and deflation, municipal bonds are safe investments due to their low default rate. Defaulting on a bond means the issuer failed to pay the interest or principal on time.

During times of rising inflation and changing interest rates, it is best to allocate funds to inflation-linked securities. One well-known inflation-linked security is a treasury inflation-protected security (TIPS). These securities are low risk because they are backed by the U.S. government and offer low inflation risk.

Real Estate

Portfolio diversification: A glass office building

Investing in real estate can hedge your portfolio stock market downturns. One way to invest in real estate that can provide excellent diversification benefits is real estate investments trusts (REITs).

Real estate investment trusts are companies that own or finance a residential or commercial income-producing property. Some examples of income-producing properties are multifamily rentals, office buildings, warehouses, and even infrastructure like cell towers.

REITs help diversify a portfolio because they have a low correlation to the stock market. This means a REIT’s performance is less likely to rise and fall as the stock market rises and falls. So if your equity investments are providing fewer returns during a down cycle, your REIT investments still may be increasing their returns.

Commodities

A portfolio that contains certain commodities can be beneficial due to the low correlation with stocks. For example, depending on the market situation, gold has a low correlation with the stock market, which provides an excellent hedging position.

However, rather than diversify with one type of commodity, such as gold, you may want to look into an exchange-traded commodity (ETC). They are similar to ETFs, except they track a basket of diversified commodities.

One common exchange-traded commodity is the SPDR Gold Trust (NYSEARCA:GLD), benchmarked to gold bullion. It is a lot easier to buy and sell shares of GLD than to buy and trade physical gold.

Use Sector Diversification

Dividing your investments between different sectors allows you to stay aligned with the U.S. economy. During volatile markets, being aware of a portfolio’s sector allocation may help handle risk while being positioned to benefit from market trends.

If you build a portfolio of stocks over time, it is essential to know how each sector complements one another. Some are highly correlated, while others perform differently depending on the macroeconomic backdrop.

For example, the consumer staples sector tends to perform well when interest rates fall, while consumer discretionary performs negatively.

Invest Across Market Caps

Market capitalization is the entire value of a publicly traded corporation’s shares of stock. All companies are categorized based on their market cap — ranging from small-cap to large-cap stocks.

Here are the basic characteristics of each market cap category:

  • Small-cap companies have a market cap of $150 million to $500 million. They can be relatively risky but have the potential for healthy growth.
  • Mid-cap companies have a market cap ranging from $500 million to $5 billion. These companies have achieved stability but are still growing.
  • Large-cap companies have market caps of $5 billion or more. These companies include the big blue-chip companies, such as Johnson & Johnson (NYSE:JNJ). Risks within these companies are sustainable to investors.

Diversifying your portfolio across all three market caps can help reduce risk in one area and support your longer-term financial goals.

Have a Globally Diversified Portfolio

Domestic economic factors — such as currency fluctuations or gross domestic product — can influence your decision to invest in another country.

Always staying globally diversified is a great way to minimize loss. By investing in equities in other countries, you have a lower correlation to the U.S. stock market. As international stocks zig, the U.S. market zags.

The U.S. represents about 30% of the world’s stock market capitalization. That leaves you with a whopping 70% of great companies to invest in globally.

Start Your Portfolio Diversification Strategy         

A stock trader looking at a chart

People get overwhelmed and stressed that their investment selections could produce massive losses or underperform. But, as long as your investment strategy includes portfolio diversification, you’ll be prepared to weather whatever market conditions come your way.

By combining different asset classes, sectors, and market caps, you will protect yourself from volatility and set yourself up for long-term success. It’s also important to offset domestic risks by including foreign stocks in your portfolio.

Now that you have a solid understanding of diversification, you’re one step closer to constructing a fully diversified portfolio. However, you need cash to pay those bills, stay retired, and safeguard your portfolio from the next crisis.

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