Published By Jake Bleicher, Equity Analyst
The benefit diversified investments has for a portfolio is simple, in theory. It reduces the impact any individual investment has on the portfolio, and proper diversification can help mitigate losses during a market downturn. In practice however, portfolios can become a large hodgepodge of various assets rather than a methodical allocation. The key is to reduce the correlation between assets so that they generally perform independent of one another.
Here are four easy ways to diversify your investments.
Think globally. Domestic companies represent less than half of the global stock market. Incorporating international assets exposes investors to the entire global economy. Global growth is not always synchronized. When one region’s economy is struggling, another may exhibit robust growth. Investors looking for low risk investments will benefit from investing in internationally developed markets. A small allocation to emerging markets can improve most portfolios, as they tend to have a low correlation to the U.S. economy.
Diversify by sector. Companies are divided into eleven sectors including consumer discretionary, energy, basic materials and technology. The sectors represent different parts of the economy and often move separately of each other. As a hypothetical example, the energy sector may perform poorly due to weak oil prices, but the consumer discretionary sector might benefit as consumers spend less on gasoline and more on entertainment and home goods.
Spread across asset classes. Based on risk tolerance, long term investments should be allocated to different asset classes. Stocks, bonds, cash, real estate and commodities are the most common liquid assets, but investors can also diversify into many types of physical assets as well. Within each asset class are sub-classes such as large, mid and small cap stocks. The various asset classes, and sub-classes within, often react differently and help to diversify an investment portfolio. Most investors can achieve optimal diversification using only stocks, bonds and cash.
Avoid over-diversification. With so many options available to investors, sometimes portfolios become overly complex. It isn’t necessary to own a little of everything. After achieving the objective of reducing correlation between investments, additional bells and whistles can increase expenses without benefitting the portfolio. There are assets that may have a negative correlation but consistently underperform and dilute returns.
In a perfect world, investors would accurately pick the best performing asset and thus diversification would be unnecessary. That isn’t reality, though, and often when going for the grand slam, investors strike out, hence the need for diversification. The point is to diversify enough to reduce risk but not so much so that it dilutes returns.
A diversified portfolio does not assure a profit or protect against loss in a declining market.
Additional risks are associated with international investing, such as currency fluctuations, political and economic stability, and differences in accounting standards.