In a world defined by economic uncertainty, geopolitical tension, and shifting consumer behaviors, relying on a single type of investment can become increasingly risky. To manage risk (not only in times of uncertainty), diversification is a fundamental strategy for investors to build a portfolio focused on long-term growth.
Rather than concentrating money in a single company, industry, sector, or asset class, investors diversify their investments across a range of different companies, industries, and asset classes. Instead of trying to pick potential winners and avoid potential losers in the market, diversification calls for owning a piece of the entire market to increase the chances of long-term success.
Diversification is more about risk management than maximizing returns, aiming to reduce volatility and potential losses in a portfolio rather than boosting returns.
Spread the Wealth
Keeping all your money in one basket, whether stocks, bonds, or real estate, exposes you to the risk of losing more during a market downturn or geopolitical event. A diversified portfolio spreads your money across multiple investments.
Different asset classes such as stocks, bonds, and real estate tend to react differently to the same economic events. If one asset class drops in value, the other investments can help offset losses and smooth out the overall performance of your portfolio.
During the pandemic, certain industries such as travel and hospitality suffered, while others such as technology and healthcare thrived. Investors with diversified portfolios benefited from the growth in these sectors even as other parts of their portfolios faced challenges.
Diversify Across and Within Asset Classes
Building a diversified portfolio involves spreading your investments across different asset classes such as equities (stocks), fixed income investments (bonds), and cash and cash equivalents. These asset classes tend to generate different returns and are subject to varying levels of risk. Including investments across asset classes is an important diversification step.
Further diversification is possible within asset classes. While stocks offer higher expected returns over the long run, they can experience substantial short-term swings. High-quality bonds, whether held through individual issued bonds or through pooled investments such as mutual funds or ETFs, often tend to generate lower returns but may provide stability. A diversified portfolio reduces overall risk while still allowing for long-term growth potential. You can seek to diversify by looking at:
- Sectors: Spread your investments across various sectors such as technology, health care, consumer discretionary spending, utilities, etc. Even within a specific industry, it can pay to be diversified.
- Bonds: Look for bonds with different maturities and from different issuers, including the U.S. government, state and local governments and corporations.
- Funds: ETFs and mutual funds can spread your investments across a broad range of asset classes, sectors, and geographies. ETFs and mutual funds offer exposure to a wide variety of asset classes and niche markets. They generally provide more diversification than a single stock or bond, and they can be used to create a diversified portfolio when funds from multiple asset classes are combined. While some funds track the overall stock market (these are known as index funds), other funds focus on specific segments of the stock market.
(When looking at funds, be careful to note the underlying securities in the fund and their overall percentage representation in the fund. Drill down into each fund you to make sure that, across funds, you are not investing in the same securities and are truly diversified. If your goal is diversification, check the types of securities in which your funds invest to make sure you’re not overly exposed to a specific investment category.)
Diversify by Location
It is a good idea to consider international exposure as a part of your diversification strategy. Be careful though, because “global” tends to include a significant portion of the U.S.; for true diversification, you want international exposure.
If you only own U.S. investments, your portfolio is subject to U.S. risk. Foreign investments can increase diversification but can be subject to country-specific risks. However, when the U.S. is facing headwinds, international investments may perform better.
Location as well as different types of investments in tax-exempt municipal bonds can also matter. Municipal bonds are debt obligations that states, cities, counties and other public entities issue to finance infrastructure projects such as building schools, highways, and sewer systems, as well as to fund the issuer’s day-to-day obligations.
There are two basic types of municipal bonds: general obligation bonds backed by the full faith and credit of the issuer, and revenue bonds backed by the revenue from specific projects such as airports, toll roads, utilities, hospitals and others.Be sure you know the difference and what particularly you are investing in.
Mistakes to Avoid
Overly diversifying: Over-diversification can dilute potential returns, while under-diversification can leave you vulnerable to market swings. A well-balanced portfolio considers your risk tolerance, investment goals, and time horizon. Sometimes too much of a good thing can be just that. Some investors attempt to diversify by investing in too many funds with overlapping holdings.
Forgetting to rebalance: Rebalancing is a negotiation between risk and reward that can help your portfolio stay on track. To maintain your preferred asset allocation, it’s important to rebalance periodically by shifting some of your portfolio’s earnings into other parts of your portfolio that may not have fared as well.
Conclusion: Keep Your Balance
While diversification may not guarantee profits or protect against all losses, a well-diversified portfolio can help smooth out market volatility and provide more consistent returns over time.
Review your portfolio to determine if it’s appropriately diversified for your financial goals, risk tolerance and time horizon.
Please be sure to check out our other pieces related to this topic:
https://bowenasset.com/mix-it-up-diversification-in-investing/
https://bowenasset.com/whats-next-entering-a-new-phase-of-uncertainty/
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