What is diversification?
Diversification refers to the practice of buying different types of assets. These different asset classes make up your portfolio.
Diversification can be done in many ways, which we'll get to in a moment. But the most important part of having diversified investments is that it provides some protection for your portfolio.
If you put all your eggs in one basket and that basket gets knocked off the table, all your eggs will break. If you had put only half your eggs in that basket and put the other half in a carton in the refrigerator and the basket fell off the table, you'd still have half your eggs safe in the fridge.
It's the same thing for your investments. If you invest solely in stocks and the market tanks, you could lose everything. Diversification means that any catastrophic loss in one area won't wipe out all your investment holdings.
How can you diversify your investments?
Creating a diversified investment plan isn't the same for everyone. What works best for you will depend on several factors, like age, gender, retirement goals, and income.
To start, you should understand what types of assets you're interested in investing in. When it comes to the stock market, there are a lot of choices, but the three main ones are:
- Stocks — Partial ownership in a company
- Bonds — Loans investors make to entities like a government or a company
- Commodities — Products, such as wheat or gold investing.
To take diversification one step further, you can also diversify even within one asset class. Take stocks, for example. You have the option of buying a mutual fund or a single individual stock. You can buy Nike stock, and you can buy a mutual fund. Now you have two different types of stock holdings. If Nike goes bankrupt, you will lose money in that holding, but you would still have your mutual fund investment.
Spreading your investments across each of these asset types is just one way to diversify your investments. The following are some other examples of diversification.
How to choose the best asset allocation model for you
There’s no “one-size-fits-all” when it comes to investing, and for this reason there are different asset allocation models that will enable you to reach your investment goals, within the scope of your risk tolerance and time horizon. Each model emphasizes a different aspect of investing — one will perform better in certain markets, and not as well in others.
The basic idea is to create the portfolio using an asset allocation that makes use of all four models, but in different measures based on your preferences. If you're unsure of which model would work for you, it might be worth talking to a wealth manager. They use technology to automate some aspects of investing, while still giving you access to a dedicated financial advisor. You can find fiduciary wealth managers near you by using directories like Paladin Registry, The Garrett Planning Network, or The CFP Board.
Let’s look at each of the four asset allocation models, keeping in mind none of them are — or need to be — a pure-play in their stated categories.
An asset allocation model that emphasizes income will favor investments that tend to provide steady income with minimal risk of principal loss due to market fluctuations.
It’s important to keep in mind this type of asset mix includes a variety of assets that will involve a certain degree of risk — however minimal — as well as at least a small chance to participate in market growth. For this reason, the performance of the model should be better than putting your money in something like a certificate of deposit.
Some of the assets you would hold in this allocation model include:
- US Treasury securities, in various maturities
- Corporate or municipal bonds
- High dividend-paying stocks
Notice that while the model emphasizes income on all assets in the portfolio, there's at least a small chance of loss particularly with bonds and stocks, depending upon market factors and the integrity of the issuing institution.
However, because of the slightly higher risk, such a portfolio should provide a rate of return at least a little above the interest and dividend yields.
2. Growth and income
A growth and income model works much like the income model, in that it emphasizes income from all investments held in the portfolio. The primary difference is in the actual asset mix.
While the income portfolio tends to emphasize security of principal, a growth and income model looks to incorporate both income and the potential for capital appreciation. To do this, the growth and income model investments are primarily in dividend-paying stocks, and less so in treasury securities or even bonds.
The idea is to generate steady income — such as dividend income — but to do so primarily from equity investments in stocks. This will enable the portfolio to provide capital appreciation, in addition to steady income.
Done properly, a growth and income asset allocation model can be one of the best performers over the long-term. This is because stocks that have a history of not only paying dividends regularly but also steadily increasing them represent one of the best long-term investments on Wall Street.
Under a growth asset allocation model, the portfolio will be invested primarily in equity-type investments — mostly stocks. Though the portfolio may hold dividend income stocks, the primary emphasis will be on companies with above-average potential growth. Many of these stocks will pay no dividends whatsoever.
The portfolio tends to be invested in blue-chip stocks with a history of growth, as well as a small allocation in treasury securities. For the latter, enough is invested to at least represent a cash position from which to buy additional stocks in the future.
A growth-oriented asset allocation model may hold a certain number of stocks belonging in the aggressive growth category — that is, stocks that fall into the high yield/ high-risk category. The idea of this model is to achieve more predictable growth than can be achieved with more aggressive investments.
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4. Aggressive growth
An aggressive growth asset allocation model will be invested primarily in high-return/high-risk equities. These positions held in such a portfolio may not provide any dividend income at all, and may also tend to avoid more predictable blue-chip stocks.
The investments held in an aggressive growth model would include stocks of companies most investors consider to be virtually speculative. Though the stocks can perform extremely well in rising markets, they are often subject to steep pullbacks in declining markets. For this reason, aggressive growth models are primarily for young people with a strong appetite for risk.
Stocks held in aggressive growth funds could include:
- Upstart companies with high performance but short track records
- Out of favor stocks — companies whose stock prices have recently been hit hard, but present speculative opportunities for rapid recovery
- Companies with high revenue growth, but little profit
- Concept stocks (like certain technology stocks) that represent cutting edge opportunities
- High risk/high reward international stocks — particularly those in developing economies
- Special plays in select industries or situations
Deciding which model works best for you
Though you might think you know which of these asset allocation models you would want to base your own portfolio on, there are actually objective factors to consider to determine which will be the best for you:
Determine your risk tolerance
If wildly fluctuating asset values will keep you up at night, you should probably go with either an income or growth and income model. If the prospect of scoring huge gains excites you — and the potential to take big losses along the way doesn’t bother you — growth or even aggressive growth may be the model for you. But you first need to determine how much risk you can comfortably handle.
Determine your goals and time horizon
If retiring in 30 years is your goal, you can and should emphasize growth or even aggressive growth. You have time to recover losses and the gains on growth-type investments can be spectacular. On the other hand, if you plan to save money to buy a house in five years, you’ll want to be more conservative since you can’t afford to take a loss that will cut into your investment principal. Income or growth and income should be your preference.
Choosing an asset mix
Once you’ve identified your risk tolerance, investment goals, and time horizon, you can set about deciding what types of assets will work best in your portfolio.
Establishing a rebalancing schedule
After setting your asset allocation, you will need to have a rebalancing schedule to make sure your portfolio model doesn’t become overweight in certain assets at the expense of others. This will be especially important in a growth and income model, where you're trying to balance income and growth (risk). At a minimum, you should plan to rebalance at least once each year, so you can reset your portfolio to your desired asset allocation.
Additional diversification options
Invest in a mix of ETFs and Mutual Funds
Investing in a mix of different exchange-traded funds (ETFs) or mutual funds allows you to tailor your investment portfolio. ETFs and mutual funds are generally more diverse than buying one or two stocks.
You should invest your money in at least five different ETFs or funds. Make sure not to have more than 25% of your money in any one of them. That way, you can spread your risk across different asset classes. At Investor Junkie, we recommend you check out Public for ETFs and mutual funds, as it provides insightful online tools to help users better manage their investments.
Invest in foreign companies and assets
Most investors are inclined to invest only in domestic assets. But if you want to diversify your portfolio truly, make sure to invest in international markets as well. While the United States is the biggest country in terms of market capitalization, global companies play an essential role in the markets. And it's good to have some exposure to other markets.
Vary your investments by company size
In addition to investing in different assets, you should also invest in different company sizes and types. You could do this by buying a mix of stocks from bigger companies, as well as a few lesser-known companies. You can also hold stock in different industries, such as health care, energy, or retailers. Also, keep in mind the risk and maturity of a company. A company that just issued an initial public offering (IPO) might have the best potential for return, but it also could have a huge risk of its stock falling. If you do invest in a risky stock, make sure to balance it by investing in a more mature stock or asset class.
How diversification gives an investor real value
Spreading your money across different investments — is truly valuable and can be done by all investors, with no additional costs. Here's an example of how diversification gives an investor something valuable for free:
Imagine you have an opportunity to buy security whose price will either go up 6% or down 4% over the next 12 months. There is an equal chance of it going up or down. We'll call this “Asset A.”
In statistical terms, Asset A has an “expected” return of 1%. (A 50% chance of going up 6% and a 50% chance of going down 4% works out to an expected return of 1%.) However, in any given 12-month period it won't actually earn that “expected” 1% — it will either gain 6% or lose 4%.
You inquire about Asset A's past performance and learn that there has been no predictable pattern to its ups and downs. Maybe it went up 6% three years in a row, then down 4% for two years, then up four years and back down for three. The pattern of “up” versus “down” has been entirely random.
You would probably consider Asset A to be a rather risky investment. I would. Even though it may feel like it should have a positive outcome in the long run, many “down” years could happen before an “up” year. It should feel risky. The chance of winning 6% isn't big enough to entice me to risk the chance of losing 4%, especially if I can lose 4% many years in a row.
Now imagine another investment, Asset B. It also goes up 6% or down 4% per year. But here's the interesting thing: Whenever A has an “up” year, B has a “down” year, and vice versa. If A goes up by 6%, B goes down by 4%. And if A goes down by 4%, B goes up by 6%. Here comes the free lunch.
If you invest equal amounts of money in A and B — in other words, if you diversify your risk between these two investments with ups and downs that are perfectly offsetting — you will definitely earn 1%. For sure. With no risk.
Let's say you invest $100 each in A and B, and this year, A goes up 6%, so B goes down 4%. You end up with $106 from A and $96 from B, a total of $202. If things had gone the other way and A had declined 4%, which would mean that B had increased 6%, you would still have $202. No matter what happens, you end up with $202. Since you started with $200 and now have $202, that's a 1% return.
The fact that B moves exactly opposite to the way A moves allows us to eliminate all of the uncertainty, also known as risk, of buying just A or just B, simply by buying both A and B. And remember, it doesn't cost us anything extra to do this. By dividing our money between these offsetting investments we eliminate the risk associated with holding just one or the other.
The downside of diversification
The example given above is greatly exaggerated. In the real world, we cannot find investment opportunities that perfectly offset each other like this, 100% of the time. But we can lower our risk without sacrificing return, simply by allocating our money across a sufficiently diverse array of investments. Here are some downsides to consider:
- When diversifying, it is important not to spread yourself too thinly. Diversification is not a bulletproof case for your investments, and it doesn't mean your investments won't go down in value.
- Spreading your money across too many investments may cause you to lose out on growth. Say you have only $100 invested in 5,000 different stocks. If one does well, you won't earn that much, because your initial investment isn't that much money. But if you had $10,000 invested in 50 stocks, you would earn significantly more should one (or more) do well. Too much diversification can mess with your bottom line.
- Diversification does offer some protection, but it doesn't fully protect you from a general market decline. In the event of a total market meltdown, where the market declines and people sell off their “safer” investments like bonds, diversification wouldn't help protect you at all, as all asset classes would decline at the same time.
Ways diversification can go bad
How can diversification end up going in the wrong direction?
Multiple asset classes aren't mutually exclusive
For many people, the name of the game with investing is growth. As a result, they find themselves with a portfolio that's heavy in growth-type investments.
If you're an investor who is young and considers himself to be aggressive, you may have 100% of your portfolio diversified in different stock sectors. The portfolio may be adequately balanced between large–, mid–, and small cap-stocks, technology, and emerging markets. Some portion also invested in growth/income stocks (in lieu of fixed income assets). All the while, thinking you're well-diversified.
Emotionally invested at the wrong time
You need to diversify intellectually, but there is a strong emotional component to investing, and it sometimes overwhelms your best intentions.
When stocks are rising strongly, you may be tempted to favor them in your portfolio. At the opposite end of the spectrum, if stocks take a beating for a couple of years (as they did during the 2007 – 2009 period), you could easily get gun-shy and invest most or all of your money in cash, cash equivalents, and fixed-income investments. But either allocation is wrong.
Even though you know you need to diversify across several asset classes, emotions based on the circumstances of the moment could cause you to go too far in a single direction.
Still, another way this could come about is through neglect. You might fail to rebalance your portfolio after a strong run-up in a certain asset class.
And you are diversified, but the problem is that you're diversified in a portfolio that is 100% stocks. Without a doubt, you've achieved excellent diversification within stocks, but you're holding nothing to counter the risk of an across-the-board decline in that asset class.
Entirely avoided certain asset classes
Some investors might limit their investment choices unnecessarily. For example, they may consider only allocating stocks and fixed investments (cash, bonds, and other fixed-income assets). In the process, they might entirely avoid asset classes that can perform well in certain market situations.
Examples could be real estate investment trusts (REITs) or resource investments, such as energy and precious metals. In certain markets, these asset classes could outperform both stocks and fixed income assets. But if you only diversify between stocks and fixed-income investments, you can miss out on these opportunities.
Investments don't follow a script
This is perhaps the biggest monkey wrench in the engine of diversification. We often assume that if we are properly diversified, our portfolios will rise or not get clobbered by virtually any type of market. But this is really where theory and reality part ways.
In certain market situations, nearly all investment classes are falling at the same time. Stocks, bonds, and commodities can all drop simultaneously, where even a substantial position in fixed-income assets still results in an overall loss of your portfolio’s value.
A perfect example of this is a time when interest rates are rising sharply. An extreme example of this type of market occurred in the early 1980s — when interest rates moved well into double digits, stocks, bonds, commodities, and even real estate lost value.
Too many accounts
If you maintain three or more investment accounts, your efforts at diversification might be undermined by confusion. The more accounts you have, the more muddled the situation is. The problem can come about by having duplicate investments in the different accounts, such that you are overweight in certain asset classes or even in specific investment securities.
You could be very well diversified in one account but very poorly in the others. This situation can easily happen to a married couple, each of whom has a 401(k) plan and an IRA, and one or two non-tax sheltered investment accounts. When adding up the positions in all your accounts, you may find that you’re not well diversified at all, but because of the sheer number of accounts, that problem exists under your radar.
So far, we've discussed situations that would cause you to be inadequately diversified, but another problem comes from the opposite direction: diversification overkill.
Perhaps as a result of trying too hard to minimize risk — or even from confused thinking — you could diversify so totally that you compromise your total investment returns.
Where you could adequately diversify within a single asset class with, say, five separate holdings, you instead spread your money across 20 different investments within the same class.
By doing so, not only could you be hurting potential gains, but you will almost certainly be incurring excessive transaction costs. Either situation will hurt your returns and defeat the whole purpose of diversifying.
The secret with diversification is balance, but you have to balance it just right. That’s the tricky part, and not at all easy to do!
Diversity is still the safest investing strategy
Diversifying is easier than it sounds, and each investor can diversify their investments; however, they want. Building a diversified portfolio is a way to protect your investments and gives you an excellent chance to find a growing investment. Take into consideration all your financial goals and present situation, and build a diversified portfolio that works for you.