Mix It Up: Diversification in Investing

One of the keys to successful investing is learning how to weigh your comfort level with risk against your time horizon (the period in which investments are held). One way to balance risk and reward in your investment portfolio is to diversify your assets.

Diversification is an investment technique designed to help reduce the volatility of your portfolio over time. By allocating investments in a portfolio across various financial instruments, asset classes, and industries—not just stocks, but also bonds, exchange-traded funds (ETFs), real estate, certificates of deposit (CDs), and savings accounts—you can reduce risk. The aim is to maximize returns by investing in varied areas that will each react differently to the same event. Unpleasant movements in one area will be offset by positive results in another.

investors means not concentrating all your eggs in one basket.

Although it does not guarantee protection against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk and volatility in your portfolio.

Risky Business

Investors face two main types of risk: systematic and unsystematic.

Systematic (or market) risk is that associated with all companies, such as inflation, exchange rates, interest rates, political instability, natural disaster, or war. This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept.

Unsystematic (or diversifiable) risk is specific to a company, industry, market, economy, or country. The sources of unsystematic risk could be poor management decisions, scandal, fickle consumers, economic downturns, changes in government rules and regulations, or unsustainable debt.

Because unsystematic risk is diversifiable, investors can reduce their exposure. The aim is to invest in various assets so they will not all be affected the same way by market events.

To build a diversified portfolio, you should look for investments—stocks, bonds, cash, or others—whose returns have not historically moved in the same direction and to the same degree. This way, even if a portion of your portfolio is declining, the rest of your portfolio is more likely to be growing, or at least not declining as much. Another important aspect of building a diversified portfolio is trying to maintain diversification within each type of investment to mitigate unsystematic risk.

Asset Management

By far, the most popular form of diversification is asset allocation. Assets include stocks, bonds, cash, real estate, gold, or other commodities. Having elements of different investment classes in your portfolio could prevent it from the value loss that it might occur if it only contained just one failing asset category.

When stock prices fall, for example, bond prices often rise because investors move their money into what is considered a less risky investment. So, when the stock market drops, a portfolio including stocks and bonds would perform differently than one including only stocks. While such a portfolio would not rise as quickly as it would with all stocks, it is also protected from a massive loss.

Diversifying within asset classes is also wise. Investors who loaded up on tech stocks in 2000 lost big when the dot-com bubble burst and technology shares rapidly fell out of favor. Similarly, financial stocks were hammered in late 2007 and early 2008 due to the subprime mortgage crisis. Anyone exclusively invested in these assets at those times would have experienced significant losses.

What Does Diversification Look Like?

There are four primary components of a diversified portfolio.

Domestic Stocks. Stocks represent the most aggressive portion of your portfolio and provide the opportunity for higher growth over the long term. However, this greater potential for growth carries a greater risk, particularly in the short term. So, if you have time to ride out the ups and downs of the market, you may want to consider investing a larger portion of your portfolio in equities.

Bonds. Most bonds provide regular interest income and are generally considered to be less volatile than stocks. They can also act as a cushion against the unpredictable ups and downs of the stock market, as they often behave differently from stocks. Investors who are more focused on safety than growth often favor U.S. Treasury or other high-quality bonds over stocks.

International Stocks. Stocks issued by non-U.S. companies often perform differently than their U.S. counterparts; they provide exposure to opportunities not offered by U.S. securities. International companies tend to be cheaply valued relative to comparable U.S. businesses, while population demographics and increasing industrialization in relatively underdeveloped countries indicate that the greatest economic growth will occur outside the U.S.

Short-Term Investments. Money maret funds are conservative investments that offer stability and easy access to your money. These funds are ideal for those looking to preserve principal. In exchange for that level of safety, money market funds usually provide lower returns than bond funds or individual bonds. While money market funds are considered safer and more conservative, however, they are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC).

Value vs. Growth

Diversification can also be found by buying the stocks or bonds of companies at different stages of the corporate life cycle. Newer, fast-growing companies have different risk and return characteristics than older, more established firms.

Companies that are rapidly growing their revenue, profits, and cash flow are called growth companies. These companies tend to have higher valuations relative to reported earnings or book value when compared to the overall market. Their rapid growth is used to justify the lofty valuations.

Value companies are those that are growing more slowly. They tend to be more established firms or companies in certain industries, such as utilities or financials. While their growth is slower, their valuations are also lower compared to the overall market.

Check out our recent report on Value vs Growth in Investing.  https://bowenasset.com/value-vs-growth-in-investing-whats-the-difference/

Conclusion: Keep Your Balance

Achieving your long-term goals requires balancing risk and reward. Setting and maintaining your strategic asset allocation are among the most important ingredients for your long-term investment success.

Always give your portfolio a regular checkup. At the very least, you should check your asset allocation once a year or any time your financial circumstances change significantly—for instance, if you lose your job or get a big bonus. Your checkup is a good time to determine if you need to rebalance your asset mix or reconsider some of your specific investments.

While diversification can reduce risk, it can’t eliminate risk altogether. Diversification reduces the risk of owning too much of one stock, and it reduces the risk of owning just stocks in general relative to other investments. However, it doesn’t eliminate market risk, which is the risk of owning any type of asset at all.