Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.
One of the keys to successful investing is learning how to balance your comfort level with risk against your time horizon. Invest your retirement nest egg too conservatively at a young age, and you run the risk that the growth rate of your investments won’t keep pace with inflation. Conversely, if you invest too aggressively when you’re older, you could leave your savings exposed to market volatility, which could erode the value of your assets at an age when you have fewer opportunities to recoup your losses.
One way to balance risk and reward in your investment portfolio is to diversify your assets. This strategy has many complex iterations, but at its root it’s simply about spreading your portfolio across several asset classes. Diversification can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of stomach-churning ups and downs. Remember, diversification does not ensure a profit or guarantee against loss.
The four primary components of a diversified portfolio
Developed Market stocks These are shares of US, UK, Japanese and EU companies. 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. Because stocks are generally more volatile than other types of assets, your investment in a stock could be worth less if and when you decide to sell it.
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 than stocks. Investors who are more focused on safety than growth often favour government or other high-quality bonds, while reducing their exposure to stocks. These investors may have to accept lower long-term returns, as many bonds especially high-quality issues generally don’t offer returns as high as stocks over the long term.
Short-term investments – These include money market funds and short-term CDs (certificates of deposit). Money market funds are conservative investments that offer stability and easy access to your money, 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.
International stocks – Stocks issued by emerging market companies often perform differently than their developed market counterparts, providing exposure to alternative opportunities. If you’re searching for investments that offer both higher potential returns and higher risk, you may want to consider adding some foreign stocks to your portfolio.
Additional components of a diversified portfolio
Sector funds – Although these invest in stocks, sector funds, as their name suggests, focus on a particular segment of the economy. They can be valuable tools for investors seeking opportunities in different phases of the economic cycle.
Commodity focused funds – While only the most experienced investors should invest in commodities, adding equity funds that focus on commodity-intensive industries to your portfolio such as oil and gas, mining, and natural resources can provide a good hedge against inflation.
Real estate funds – Real estate funds, including real estate investment trusts (REITs), can also play a role in diversifying your portfolio and providing some protection against the risk of inflation.
Asset allocation funds – For investors who don’t have the time or the expertise to build a diversified portfolio, asset allocation funds can serve as an effective single-fund strategy as the asset allocation is managed for you by the manager.
The primary goal of diversification isn’t to maximize returns. Its primary goal is to limit the impact of volatility on a portfolio. To better understand this concept let us consider some hypothetical portfolios with different asset allocations. We have looked at the average annual return for each hypothetical portfolio from 1926 through end 2018, including reinvested dividends and other earnings.
The most aggressive portfolio – comprised of 70% developed market stocks and 30% international stocks, had an average annual return of 10%. Its best one-year return was nearly 163%, while in its worst year it would have lost nearly 68%. That’s probably too much volatility for most investors to endure.
Changing the asset allocation slightly, however, tightened the range of those swings very volatile swings without giving up too much in the way of long-term performance. For instance, a portfolio with an allocation of 49% developed market stocks, 21% international stocks, 25% bonds, and 5% short-term investments would have generated average annual returns of almost 9% over the same period, albeit with a narrower range of extremes on the high and low end with a best single year performance of 109% and a worst year of -52%. When looking at the other asset allocations, adding more fixed income investments to a portfolio will slightly reduce one’s expectations for long-term returns, but may significantly reduce the impact of market volatility. This is a trade-off many investors feel is worthwhile, particularly as they get older and more risk-averse.
Factoring time into your diversification strategy
People are accustomed to thinking about their savings in terms of goals: retirement, education, a down payment, or a vacation. But as you build and manage your asset allocation regardless of which goal you’re pursuing there are two important things to consider. The first is the number of years until you expect to need the money also known as your time horizon. The second is your attitude toward risk also known as your risk tolerance.
For instance, think about a goal that’s 25 years away, like retirement. Because your time horizon is fairly long, you may be willing to take on additional risk in pursuit of long-term growth, under the assumption that you’ll usually have time to regain lost ground in the event of a short-term market decline. In that case, a higher exposure to domestic and international stocks may be appropriate.
But here’s where your risk tolerance becomes a factor. Regardless of your time horizon, you should only take on a level of risk with which you’re comfortable. The other thing to remember about your time horizon is that it’s constantly changing. So, let’s say your retirement is now 10 years away instead of 25 years you may want to reallocate your assets to help reduce your exposure to higher-risk investments in favor of more conservative ones, like bond or money market funds.
Once you’ve entered retirement, a large portion of your portfolio should be in more stable, lower-risk investments that can potentially generate income. But even in retirement, diversification is key to helping you manage risk. At this point in your life, your biggest risk is outliving your assets. So just as you should never be 100% invested in stocks, it’s probably a good idea to never be 100% allocated in short-term investments if your time horizon is greater than one year. After all, even in retirement you will need a certain exposure to growth-oriented investments to combat inflation and help ensure your assets last for what could be a decades-long retirement.
Regardless of your goal, your time horizon, or your risk tolerance, a diversified portfolio is the foundation of any smart investment strategy.