Because stocks and other investments change in value over time, investors may find that one or two securities make up a large portion of their overall portfolio. It can be helpful to occasionally review your portfolio for ways to improve diversification and ensure your fortune isn’t tied to one or two investments.
What is diversification?
Diversification is a way to manage risk in your portfolio by investing in different asset classes and different investments within asset classes.
Diversification is an important part of any investment plan and ultimately means recognizing that the future is uncertain and no one knows exactly what will happen. If you knew the future, there would be no need to diversify your investments. But by diversifying your portfolio, you can smooth out the inevitable peaks and valleys of investing, making it more likely that you’ll stick to your investment plan and possibly even achieve higher returns.
6 diversification strategies to consider
Here are some important tips to keep in mind so you can diversify your portfolio.
1. It’s not just about stocks versus bonds
When most people think of a diversified investment portfolio, they probably imagine a combination of stocks and bonds. For decades, financial advisors have used the ratio of stocks to bonds in a portfolio to measure diversification and manage risk. But that’s not the only way to think about diversification.
Over time, portfolios can gain excessive exposure to certain asset classes or even specific sectors and industries within the economy. Investors who owned a diversified portfolio of technology stocks in the late 1990s were not actually diversified because the underlying companies they owned were tied to the same trends and factors. The Nasdaq Composite index, which largely tracks technology stocks, fell nearly 80 percent from its peak in March 2000 to its trough in the fall of 2002.
Make sure you think about the industries and sectors you are exposed to in your portfolio. If an area is overweighted, consider reducing it to maintain good diversification in your portfolio.
2. Use index funds to increase your diversification
Index funds are an excellent way to build a diversified portfolio at a low cost. By purchasing ETFs or mutual funds that track broad indexes such as the S&P 500, you can buy into a portfolio with virtually no management fees. This approach is easier than trying to build a portfolio from scratch and monitoring which companies and sectors you are exposed to.
If you’re interested in a more practical approach, index funds can also be used to add exposure to specific industries or sectors that you may be underweight. These funds can be more expensive than those that track the most popular indexes, but if you’re interested in a slightly more active approach to managing your portfolio, they can be a quick way to add exposure to certain sectors.
3. Don’t forget cash
Cash is often overlooked when building a portfolio, but it does come with certain benefits. While it is almost certain that cash will lose value over time due to inflation, it can provide protection in the event of a market sell-off. Depending on the amount of cash in your portfolio and other investments you hold, cash can help your portfolio decline less than the market average during a recession.
Cash also gives its holders options. This means that the value does not come from holding the cash itself, but rather from the options that cash gives you when the future environment is different than today. Most people tend to think about the investment opportunities that are currently available to them and ignore what might be available in the future. But if you have some cash in your portfolio, you’ll be well-positioned to take advantage of any future investment bargains when the next market downturn arrives.
4. Target date funds can make it easier
Another way to maintain a diversified portfolio is by investing in target date funds. These funds allow you to choose a date in the future as your investment goal, which is often your retirement. When you are far from the goal, the fund invests in riskier, higher-return assets, such as stocks, and then shifts the portfolio allocation to safer, lower-return assets, such as bonds or cash, as you get closer to your goal. You’ll want to understand how the fund invests, but these can be great for people looking for a more ‘set it and forget it’ approach.
5. Periodic rebalancing helps you stay on track
Over time, the size of the investments in your portfolio will change depending on how the investment performs. Strong performing companies will become a larger percentage of your total portfolio, while the worst performing companies will see their weight diminish. To maintain a diversified portfolio, it is generally a good idea to occasionally rebalance the portfolio to the appropriate weight for each investment. You probably don’t need to do this more often than quarterly, but you should check on things at least twice a year.
6. Think globally with your investments
With so many different investment options available in the US, it can be easy to forget about the rest of the world. But in a global economy, there are increasingly attractive opportunities beyond a country’s borders. If your portfolio is entirely US-focused, it may be worth looking at funds that focus on emerging markets or Europe. Because countries like China grow faster than the US in the long term, companies based there can benefit.
International diversification can also be a way to better protect yourself from negative events that could only affect the US. Other markets may not suffer as much if the US sees an economic slowdown. Of course, the reverse also applies. Emerging markets sometimes face challenges due to their underdeveloped economies and financial markets, disrupting their longer-term growth trajectory. But diversifying your portfolio is about smoothing out the inevitable bumps, wherever they come from.
Can you be overdiversified?
While diversification is an important practice for most investment portfolios, the concept can be taken too far. Not all investments add diversification benefits to a portfolio, so it’s important to watch out for overlapping investments to avoid holding an over-diversified portfolio.
If you hold multiple funds in the same category, such as multiple small-cap stock funds or total stock market funds, you probably won’t benefit much from the additional funds. It’s like packing for a trip where you don’t know what the weather will be like and taking four umbrellas with you; one umbrella is probably enough.
You should also beware of funds of funds, which are funds made up of several other funds. These typically come at a high cost and are unlikely to add diversification to your portfolio. Focus on holding just one or two funds in each category and think about how different investments will interact with each other. You’ll get the most diversification benefit by holding uncorrelated assets, or assets that move in opposite directions from each other.
In short
Diversification is ultimately about accepting an uncertain future and taking steps to protect yourself from that uncertainty. Reviewing your portfolio a few times a year can help keep your long-term plan on track and ensure your goals aren’t tied to one or two investments.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making any investment decision. In addition, investors are advised that the past performance of investment products does not guarantee future price increases.
