Everyone’s heard the old chestnut about putting all your eggs in one basket. It’s just common sense. If you have two baskets and drop one, you’ve still got some eggs. You’ve reduced the risk of having no eggs at all.
Roughly the same idea applies to investment portfolios. Diversification means investing in securities that are subject to different types of risk and opportunities and, as a result, can have low to negative correlation.
When two things are correlated, they move in the same direction. When there’s no correlation, they move independently. When there’s negative correlation, they move in opposite directions.
Choosing investment vehicles, whether individual securities or funds, that offer low to negative correlation with one another is the key to constructing a diversified portfolio.
It’s important to understand that diversification isn’t intended to maximize returns; it’s a strategy to mitigate portfolio risk and help minimize volatility.
There’s no guarantee that an investor with a diversified portfolio will outperform an investor with a concentrated portfolio or that it won’t lose money. For example, if you invested in all tech stocks during a boom, you could significantly outperform a diversified portfolio. But the eggs, in this case tech stocks, are all in one basket. A diversified portfolio will be insulated from large losses when the bubble bursts, while the concentrated portfolio will take a big hit. Based on historical data from the Kenneth R. French data library at Tuck University, diversified portfolios have tended to outperform concentrated portfolios over the long term.1
For long-term investors, risk mitigation can be crucial. Over time, markets are prone to cycles of volatility, economic upheavals, and unanticipated events. Diversification can help smooth out the impact of these gyrations. While one sector may underperform during a downturn, others may remain stable or even do well. Maintaining steady growth and resilience is essential for those investing over decades to achieve goals such as retirement, funding college, or building generational wealth.
The first step in diversification is including different asset classes in your portfolio. It starts with choosing how much to invest in stocks versus bonds.
Stocks and bonds, as asset classes, historically have tended to move in different directions.2 When stock prices rose, the bond market tended to head south. The converse has also been true; when the stock market was doing poorly, the bond market performed well. The stock market is volatile and bears more risk, so it offers more potential for growth than fixed income does. While bonds may generate lower returns, those returns tend to be more stable.
How an investor diversifies between stocks and bonds depends on things like investment goals, comfort with risk, and time horizon. For example, it’s a generally accepted rule of thumb that younger investors with a longer time horizon would allocate more capital to stocks. As that investor ages, the equity allocation would decrease while the amount invested in fixed income would grow.
Diversification entails more than just deciding on how much to allocate between stocks and bonds. While these asset classes play the largest roles in most portfolios, allocations to other assets as well can increase diversification.
For example, commodities have tended to have a low correlation with both stocks and bonds, as does real estate. Many alternative investments like hedge funds can offer a low correlation to equity while increasing potential portfolio returns but may be much more difficult for the average investor to access.3 For long-term investors, including these different asset classes can potentially add layers of protection to help minimize market volatility.
You can also diversify within asset classes. Let’s take stocks, for example. You might diversify by industry, because different industries are affected differently by various economic environments.
For example, an inflationary environment generally has a negative impact on the stock market since spending, especially consumer spending, declines. Within that environment, however, some sectors react more strongly than others. Companies in the consumer discretionary sector often decline, but the consumer staples sector can be less affected because companies in this sector make staple products people often can’t easily go without. We think healthcare is also less likely to take a big hit because there can be little consumer discretion involved in its consumption.
There are plenty of other ways to diversify too. Choosing large cap and small cap companies is an option as small caps tend to bear higher risk but may offer more return.4 Growth and value strategies tend to be negatively correlated, and when one does well the other languishes. Geography is another source of diversification; choose between emerging and developed markets, or US and Europe, for example.
Within the fixed income portion of your portfolio, you can balance your holdings between different levels of credit risk (as measured by agency ratings) and different levels of interest rate risk, which is a function of a bond’s time to maturity. Longer bonds have higher interest rates since there is greater uncertainty about rates over the longer period.
For long-term investors, a variety of international and sector exposures can keep a portfolio from being too reliant on any one region or industry, both of which could be subject to unexpected declines.
It should be clear by now that we believe it’s wise to both include a range of investments in your portfolio and pay close attention to asset allocation. That doesn’t mean it’s easy; it can be overwhelming to sift through and choose wisely out of all the choices available.
One strategy is to choose a handful of ETFs that cover different asset classes, sectors, or market caps. The funds themselves will be diversified across different companies, providing the investor with diversification that can support a strong long-term investment plan. Motley Fool Asset Management offers six funds addressing different strategies, market caps, and geographies you might consider as you diversify your investments.