High returns alone don’t necessarily translate to long-term success. Markets swing. Sectors boom and bust. Individual stocks can flounder. If your portfolio leans too heavily on one investment, industry, or asset class, a downturn can wipe out years of gains. That’s why the main goal of most investors should be to maximize their return while minimizing the risk of loss. Preservation is especially important if you’re nearing retirement or managing a significant amount of wealth.
Portfolio diversification is one way to achieve this goal. Diversification is a strategy designed to lower risk while supporting long-term returns by allocating investment assets to different classes. This is sometimes referred to as “not putting all your eggs in one basket.” In this article, we will describe the role of diversification in creating an investment portfolio. We’ll explain how diversification works, why it’s important, and how different asset classes interact to create a resilient portfolio.
What Is Diversification?
Portfolio diversification is the practice of spreading your investments across different asset classes, such as stocks, bonds, alternatives, and cash equivalents, to balance risk and reward without sacrificing growth.
Diversification is based on the idea that various asset classes react differently to changing market conditions. In other words, while one type of asset zigs, another type might zag. Having a well-diversified portfolio can help smooth out returns while reducing the impact of a single underperforming asset.
For example, if stocks — which can be highly volatile — decline, this can be offset by bonds and cash equivalents, which are generally more stable.
When diversifying your portfolio, the goal is to choose asset classes that have less or even negative correlation to each other. Correlation represents the relationship between the price movements of different assets. In simpler terms, when the prices of one asset class are moving down, the prices of another asset class tend to be moving up, and vice versa.
Historically, stocks and bonds have had a negative correlation, although that hasn’t been the case the past few years. This is why a balanced portfolio usually contains a mix of stocks, bonds, and other less correlated assets, so the positive performance of one asset class can offset the negative performance of the other class.
Benefits and Trade-offs of Diversification
The biggest benefit of diversification is that it lowers overall risk and volatility while increasing the potential for more stable returns. In the short term, investment returns can vary widely between asset classes, which can make a lack of diversification a high-risk proposition.
Consider a portfolio highly concentrated in technology stocks. Between November 2020 and November 2021, the tech-heavy Nasdaq Composite Index rose from 10,957 to 16,057, or 47%.1 But over the next year, the Nasdaq fell to 10,524 — below where it stood two years earlier.
This investor might have gotten whiplash from the wild two-year ride! Adding other asset classes to their portfolio, such as bonds and cash equivalents, could have reduced volatility and smoothed out the return over this time period.
Think of diversification as the tortoise — steady, reliable, and paced for long-term success. It usually delivers relatively stable investment performance and more consistent returns over time, rarely rising or falling too drastically. Lower volatility may not deliver meteoric rises like a concentrated position in a single stock or sector, but it also helps you avoid the dramatic crashes that can derail progress toward goals.
Three Traditional Asset Classes
There are three traditional asset classes to choose from when building a well-diversified investment portfolio:
- Stocks — Securities that provide ownership shares in public companies. Investors may benefit from appreciation in share prices over time, as well as dividend payments from companies that pay them.
- Bonds — These are debt instruments issued by government entities and corporations to raise money. Bonds pay a fixed interest rate over a set period of time. Upon maturity, the investor receives the original face value of the bond, plus interest. Businesses issue corporate bonds while the federal government issues Treasury bonds and state and local governments issue municipal bonds.
- Cash equivalents — These include bank savings accounts, money market vehicles, certificates of deposit (CDs), Treasury bills, and other short-term investments. Cash equivalents are low-risk, low-reward investments so they can be used to offset some of the risk and volatility of stocks in a portfolio.
You can also diversify holdings within a particular asset class. With stocks, for example, you could hold international and domestic stocks, as well as the securities of small-cap, mid-cap, and large-cap companies. You can further diversify your stock portfolio by investing in companies across a wide range of different industries such as energy, healthcare, technology, retail, and telecommunications.
Similarly, you can diversify fixed-income investments by purchasing bonds from different issuers and with varying maturities and credit ratings. For instance, you could invest in a mix of investment-grade and high-yield corporate bonds along with U.S. Treasury bills of different maturities and municipal bonds from various regions of the country.
Alternative Assets for Greater Diversification
There’s another asset class that can help you take diversification a step further: alternative investments. These assets usually have a low (or even negative) correlation with the traditional asset classes, which can make them serviceable diversifiers.
- Real estate — This includes land, apartment and office buildings, warehouses, and retail shopping centers. Real estate investment trusts (REITs) are a popular way for individuals to invest in real estate without owning and managing property directly.
- Private Equity: Private equity funds pool capital from investors to acquire ownership stakes in private companies, aiming to enhance their value over time and sell them for a profit. These funds are typically closed-end and have long investment horizons.
- Private Credit: These funds pool capital from investors to make loans to private companies, generating income through interest payments. They offer access to higher-yielding, illiquid debt investments.
- Hedge Funds: Hedge funds are actively managed investment vehicles that use a wide range of strategies—such as long/short equity, arbitrage, and derivatives—to generate returns in various market conditions. As an asset class, they aim to deliver absolute returns with low correlation to traditional markets, but typically come with higher fees, less liquidity, and greater complexity.
- Venture Capital: These funds invest in early-stage, high-growth startups with the potential for significant returns. While it offers an exciting upside potential, it also carries high risk and illiquidity, making it best suited for long-term, experienced investors.
How to Build a Diversified Portfolio
There are several different factors to consider when building a diversified portfolio, including your investing time horizon, risk tolerance, and overall financial goals.
Generally speaking, the longer your time horizon, the more risk you can afford to assume in your portfolio. This is because you’ll have more time to recoup potential short-term losses caused by market volatility. For example, a 30-year-old investing for retirement can probably allocate a higher percentage of their portfolio to stocks than a 55-year-old who wants to retire in 10 years.
When it comes to risk tolerance, only you can decide how much investment risk you’re comfortable with (although an advisor can help talk you through it). If you stress about losing money when the markets are volatile, then you probably have a lower risk tolerance and should allocate a lower percentage of assets to stocks. But if you can ride out times of volatility without losing sleep at night, you might be more comfortable with a higher percentage of stocks and alternative investments in your portfolio.
The Importance of Rebalancing
Portfolio diversification isn’t something you can just “set and forget.” As asset prices rise and fall over time, this will shift their relative weighting, resulting in the need to rebalance your portfolio.
For example, let’s assume that your desired asset allocation is 60% stocks, 30% bonds, and 10% cash equivalents. Over the past two years, broad U.S. stock markets have risen significantly, which has lifted your portfolio’s stock allocation to 70%. To re-align your asset allocation, you would need to sell some equity positions and use the money to buy fixed income and/or cash equivalents until your asset mix is back at 60/30/10.
You can rebalance your portfolio at regular intervals, such as annually, or when your portfolio deviates from your desired target mix by a certain amount. For instance, you might decide to rebalance whenever your asset allocation shifts by more than 5% from your desired mix of asset classes.
Experiencing certain life events or milestones could also necessitate rebalancing your portfolio. These might include getting married or divorced, having a child, buying a home, losing a job, changing careers, receiving a cash windfall (such as an inheritance), or going through a health crisis.
Common Diversification Mistakes
It’s possible to over-diversify by holding too many investments across different asset classes in your portfolio. This can dilute returns and make it hard to manage your portfolio effectively. On the flip side, you can also under-diversify by not spreading your assets out among enough securities in different classes.
Investing in assets with a positive correlation is another diversification mistake. For example, high-yield bonds and stocks are highly correlated — in other words, their prices tend to move in the same direction. So, if you’re too heavily invested in these assets, you won’t achieve adequate diversification.
Some investors also neglect to rebalance their portfolios periodically. As noted above, this may result in a portfolio with a higher or lower percentage of assets across classes than you desire, which could make it harder to achieve your investing goals.
Why Diversification Is Crucial
Diversification is a crucial strategy for managing portfolio risk and maximizing long-term investment returns. Success requires careful planning, ongoing monitoring, and periodic rebalancing based on changes in asset prices over time.
If you have more questions about diversification, Simon Quick Advisors is here to help. Schedule a free consultation with one of our advisors today to discuss how we can help you build a well-diversified portfolio designed to meet your investing objectives.
Sources:
1 Nasdaq, “NASDAQ Composite Index (COMP) Historical Data”
2 Nasdaq, “NASDAQ Composite Index (COMP) Historical Data”
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