Portfolio Diversification 101

Do you want to minimize the risk of your investments while maximizing your profits? 

Of course you do! But you know that there’s always a risk of losing it all, even if you’ve meticulously studied the market and your stock choices. And there’s a lot at stake here—your early retirement and your children’s college fund depend on the money. 💰

It’s easy to fantasize about buying the right stock at the right time and can help you achieve all your financial goals. But the truth is, sometimes you have to play the long game the right way to reap the most benefits. 

Portfolio diversification is often considered the gold standard of investment. Even if you’re not the most intuitive investor, you can often secure long-term financial gains with minimal risks. 

So, in this article, we will discuss the logic behind diversification, as well as the best ways to go about it according to your financial goal—keep in mind, there are many pitfalls to avoid when diversifying too. So, without further ado, let’s get straight to it.

What is Portfolio Diversification? 📖

Think of it this way—if you have $1,000 to bet on a horse, would you bet it all on one horse? Or would you spread it out and increase the chances of a win?

In essence, portfolio diversification is the strategy of not putting all your nest eggs in one asset basket. It is based on Modern Portfolio Theory, which was created by an economist named Harry Markowitz. Markowitz won a Nobel prize for this theory in 1990 and a John von Neumann prize the year before.

The idea is that you’re less likely to sustain long-term losses if you invest in multiple asset classes across industries. With proper asset allocation, you can dampen the impact of underperforming stocks and maximize your profits in the long run. 

To this day, many investors continue to use diversification strategies to manage their risks. By understanding the concept and what goes into an ideal portfolio mix, you’ll be able to invest safely without bearing the brunt of a badly-placed investment. 

Why is Asset Correlation Important? 💡

In a well-diversified portfolio, you’d want your asset groups to have as little to do with each other as possible. The idea is to invest in a bunch of different assets so that your risk is minimized. But, do you know that you can also use maths to determine how close together your assets are? 

Assets correlation represents the degree of relationship between the price movement of two or more assets, with +1 to mean your assets move together price-wise and -1 to indicate that they move in opposite directions. Theoretically speaking, your portfolio is the safest if all the assets correlate -1. Using this depiction, you should accurately predict how independent your purchases are from each other. 

Since perfectly uncorrelated pairs are pretty rare on the stock market, your best bet would be to open up the distance between your pairs. For example: 

• The correlation between assets A and B is +0.26
• The correlation between assets A and C is +0.64
• The correlation between assets B and C is -0.05

In this case, you could say that assets B and C are less closely correlated than the other pairs, and therefore are the least risky of them all. 

That being said, it’s essential not to get caught up by the nitty-gritty of the numbers game. There are always anomalies—sometimes, a low-correlated pair could be impacted by the same market changes and vice versa. The whole point of calculating asset correlation is to get assets that are not likely to be affected by one another, so keep that in mind when you’re selecting your investments. 

Why Diversify Your Portfolio? 🗄️

First, ask yourself: would you go all-in on a poker game if you only have an okay hand? 

When you put all your money into one single stock, you’re banking everything onto a probability that might not pay off. Companies in the same industry tend to mirror each other—if one goes down, the other follows. Besides that, they could also be influenced by the same factors, like new government regulations, change of ownership, or even unexpected scandals. 

You stand a much better chance of getting a net gain if you split your investment into a few types of assets and scatter them across industries. That way, even if one of your investments is performing poorly, you’d probably still profit from your other assets in the long run. 

The logic here is that a wide range of assets in different industries are less likely to perform poorly all at once. They would be more likely to offset and balance each other when one doesn’t hit the mark. As long as some of them soar, you’d be able to achieve your long-term goals with them. 

The COVID-19 pandemic is the perfect advocate for portfolio diversification. Let’s just take Boeing and Zoom as examples. 

As you can see, Boeing has lost about 60% of its value in just three weeks in March from COVID fears, unfortunate accidents, and mismanagement. Meanwhile, Zoom is seeing unprecedented growth that didn’t seem to be capping out anytime soon.  

Hindsight is 20/20, of course, but if you invested all your money on airlines like Boeing or Delta, you’d lose quite a lot of money from the impact of the pandemic. However, if you diversified your portfolio and put some cash into Zoom, you’d at least earn enough to cover your losses and even gain some profit. 

Some might argue that putting all your money into the communications sector would net a big pot of gold. But we all know nothing is truly certain on the stock market since it is very susceptible to changes. Besides a global pandemic, a vaguely-worded change in government regulations, CEO changes, or scandals are just among some of the factors that cause a stock to plummet. 

Diversification doesn’t only involve stocks—defensive assets like bonds and commodities are significant investments for a well-diversified portfolio. They are generally considered more stable and secure, protecting you from sudden drops in the stock market. 

Besides that, a diversified portfolio would also require minimal maintenance. If you’re invested solely in equity shares, you’ll be spending a lot of time studying market movement and analyzing your next step. The same goes for finding more ways to increase returns with low-risk bonds. 

The Dangers of Overdiversification ☠️

While not a foolproof strategy, diversification effectively protects you from unnecessary risks and losses. When your investment portfolio is diversified enough, drops in any given stock shouldn’t affect your overall gain too much. 

Many investors make the mistake of thinking that risk is proportionately reduced with every stock they buy. In actual fact, the more stocks you buy, the harder it is for your stock portfolio to perform optimally. 

For example, if your portfolio includes a S&P 500 index fund and an ETF of tech stocks, you’ve most likely over-diversified your portfolio. That’s because IT stocks make up almost 28% of the index fund, making it counterproductive to get more tech securities since they are all affected by the same factors. 

It’s a common mistake that investors make when they acquire a large amount of assets. When your portfolio is too big, you’re more likely to accidentally buy stocks that highly correlate to your existing portfolio. This makes it significantly harder to reach your financial goals since your losses are more impactful than your profits. 

It’s important to remember that diversification can only reduce your risk up to a certain point. Because of how unpredictable the stock market is, diversification for diversification’s sake is never a good idea. Quality is always better than quantity. 

What Makes a Portfolio Diversified? 📖

What is your financial end goal? When do you want your investments to pay out? How risk-averse are you? 

By asking these questions, you can properly allocate your assets based on a risk level and return potential that you are 100% comfortable with. Say, if you want to retire in 20 years with $100,000 in your bank account and $5,000 to invest, you’d have to include fewer fixed-income investments and more stocks. 

Some financial advisors recommend building a conservative 60/40 portfolio—60% to stocks and 40% to defensive assets. This is generally a good ratio for low-risk investors since you don’t put too much investment capital at stake. 

However, there is no hard and fast rule when it comes to diversifying your portfolio. Some investors prefer to go 70/30 for more profits, or even 20/80 with 80% in stocks. As long as your investment portfolio contains a good mix of stocks, bonds, real estate, and commodities, you’re good! 👍🏽

In this section, we’ll go over some of the elements that should make up a well-diversified investment portfolio. 

The Role of Stocks in Diversification 📈

Stocks are often the go-to for many novice investors since they are easy to buy and stay ahead of inflation. In the best-case scenario, they grow with the economy, giving you great dividends and high returns after holding onto them for a while. 

However, they are also subject to market volatility, the performance of the company, and other factors out of your control. Without proper research and thought, your stint in the stock market may be short lived and financially scar you for life. 

Instead of putting your entire pot of gold in rapidly-growing tech stocks, try to mix up your portfolio with other industries like healthcare, entertainment, and automobiles. Every industry has its ups and downs, so having a healthy spread of stocks across all sectors would maximize your gains while reducing the risk of losing it all. 

The first instinct for many investors is to invest in stocks from giant companies like Apple or Google since their profits are almost guaranteed. But knowing how to invest in smaller companies might multiply your profits since there is more room to grow. Besides that, you can also invest in foreign markets to take advantage of the growth, especially if the US market is stagnating.

Using Bonds to Diversify 💸

Although bonds typically have a higher entry requirement, they are the preferred non-correlated investments since they are usually more stable and secure. In the event of liquidation, bondholders (you) would be paid first over shareholders. You would also know more or less how much you’d get when your bond matures. 

On the flip side, many investors often overlook the higher interest rate in exchange for financial security. You might also not get as much as you expected when your bonds mature with high interest rates and inflation. Not only that, but bonds typically require a much more significant sum of investment and are less liquid than stocks. 

If security is your priority, your best bet is to purchase some AAA bonds, which are considered the most secure type that almost always pay out. Bonds are rated from AAA to C, with BB and lower (junk bonds) having higher yields due to higher default rates. 

Diversifying with Exchange-Traded Funds (ETFs) 💱

EFTs are one of the most popular assets for passive, risk-averse investors. They are very similar to mutual funds since it is a bundle of securities consisting of various stocks, bonds, or commodities. As implied from the name, this asset class is traded during the day on the exchange. 

Like a diversified portfolio, it’s unlikely for all the assets in the fund to plummet all at once, making it a much safer investment option than stocks. Besides that, some firms also offer dividends to their investors that they can funnel back into the fund or cash out. 

There are six types of EFTs—index, industry, commodity, actively managed, foreign market, and inverse. Each type has its characteristics, strengths, and weaknesses, so choose the ones that work best with your financial goals and risk appetite.    

Can You Diversify with Gold? 🏅

Although it can be volatile in the short term, gold has a history of holding its value through the ages. This asset class also typically increases in price when bond and stock prices fall in recessions, which is why it should be an important part of a diversified investment portfolio. 

Many investors tap into their inner Smaug and physically hoard gold when in actuality, they could be more trouble than they are worth. Instead, you can try investing in a range of gold EFTs and gold mining stocks. Although there’s always a risk with gold, especially when it comes to the production of gold mines, this is a great asset class for medium to long-term investments. 

Real Estate Investment Trusts (REITs) 🏠

A REIT offers you an opportunity to make income by partially owning commercial real estate like apartments or offices. However, you not only own a bit of the land with REITs, but you also get a small portion of the income generated by the occupants. 

Many investors compare REITs to stocks since they are very similar, but REITs are also required to pay  90% of their net income to their shareholders. That means you get income from owning a REIT unit plus the money generated by the lessor of the unit. While it won’t pay off your mortgage in a month, it brings a stable cash flow, making it a good defensive option in a diversified portfolio. You can also opt for diversified REITs, which contain numerous types of properties. 

How to Diversify Your Portfolio 🗂️

There is no universally correct way to diversify your portfolio—your investment portfolio works for you if it gives you the profits and matches your risk appetite. You can even use your Sheldon Cooper-esque powers with different apps and formulas to diversify your investment portfolio if you want. Here are some tried-and-tested tips that you can draw from to diversify your portfolio. 

Buy at Least Ten Stocks Across Industries 💲

Many investors put all their chips in a high-reward lucrative industry like tech, industrial, or pharmaceuticals. However, investing in multiple companies in the same industry doesn’t count as proper diversification since you’re pretty much screwed by an unexpected event like an economic downturn.

You can use naive or optimal diversification to choose the stocks you should buy. Naive diversification simply means you go with your gut and select the stocks at random. Although not very sophisticated, it can be an effective strategy if your decisions are driven by experience and thought. 

Optimal diversification is usually calculated with algorithms and programs to find assets that are the least positively correlated with each other. While more accurate, it is much more complex and is probably above the average investor. 

Invest in Foreign Markets 💵

Investing in foreign stocks or stocks with foreign exposures can significantly diversify your portfolio. For one, you can minimize the risk of your portfolio as foreign stocks are less likely to be positively correlated to the price movement of American stocks. 

But the chief reason for investing in foreign stocks lies in expanding your opportunities as you can take advantage of the growth in foreign markets if the US market is stagnating. 

Historically speaking, domestic and international stocks alternate in performance, which means it’s very likely for foreign markets to outperform the domestic market at one point in your life. For example, although large-cap US stocks returned at 22% in 2017, the MSCI EAFE (essentially the global S&P 500) performed much better at 25.6%. So if your capital is only invested in the US market, you would have missed out on the extra profit.  

Put a Portion of Your Portfolio into Fixed-Income Investments 🍱

Like we’ve mentioned before, it’s essential to diversify your portfolio with fixed-income assets like bonds or gold. Although they won’t bring you to your first million, they are typically great investments for reducing your portfolio’s overall risk profile. 

The ratio of fixed-income/stocks is up to you, but the risk increases with the percentage of stocks you put in your portfolio. Conversely, you’d also see lower potential annual returns if you choose to invest in more defensive assets.  

Don’t Overlook Market Laggards ✅

It can be very tempting to put all your money into market leaders that are almost guaranteed to be unphased in the face of crises. But look at it this way—how much would you have earned if you held some Apple stocks from the 1990s? 

Having small companies and market laggards on your portfolio is as equally crucial as holding blue-chip stocks. Some of these overlooked or out-of-fashion stores have the potential for high profits long term while being relatively low risk, especially if you have the foresight to see what they could be in the future. 

Rebalance Your Portfolio Every Once in a While 🤹🏾

Although a well-diversified portfolio doesn’t require constant monitoring, it certainly isn’t a one-time thing. Since prices of securities constantly change, you’d need to rebalance your portfolio and bring it back on track every once in a while. 

Depending on what you want to achieve and how terrified of risks you are, you can either sell the highest-performing ones for new funds to reinvest or invest new capital for newer assets. There’s no right way to rebalance your portfolio either as long as it helps achieve your financial goals.  

How to Diversify Your 401(k) 🔄

When you allocate your 401(k), you’re directing the money you contribute towards the investment of your choice. Regardless of your risk and reward tolerance, you should continuously diversify your 401(k) so that your assets are not overly weighted on one industry or company. 

Target-Date Funds 🎯

One of the easiest ways to diversify your 401(k) is by investing your money into a target-date fund geared toward people who plan to retire at a specific time. These funds spread your 401(k) money across multiple asset classes, including large-company stocks, small-company, emerging-markets, real estate, and bonds. 

Target-date funds make long-term investing easy with the end date. If you plan to retire around 2050, you should pick a target-date fund with ‘2050’ in the name. You don’t have to do anything but keep contributing to your 401(k) after investing in the fund—it does everything for you!  

Another benefit of using target-date funds is that it automatically moves your contribution between asset classes in a way that supports your retirement goal. The closer you are to your target date, the more conservative it’ll be. That way, you’d have a nice nest egg waiting for you at your retirement age. 

Although it was designed to reduce investment risk, there’s always a risk of losing your money. So before you invest into a target-date fund, you should always make sure that you’re 100% on board with your glide path—the gradual investment of your 401(k). 

Balanced Funds ⚖️

You can use a balanced fund to diversify your 401(k) if you’re more conservative. A balanced fund is a mutual fund with a more conservative mix of bonds and stocks. Typically, it would consist of 60% of your 401(k) bonds and 40% stocks. 

It’s a low-risk, moderate-reward approach since you won’t be too bothered about market volatility. No matter how the stock market does, you’d still have some security since you own more bonds. 

The downside is that you won’t see overwhelming returns on your funds either when the market is bullish. And since the point of using a balanced fund is to minimize the risk, some investors play it too safe, resulting in meager returns. 

Benefits of a Diversified Portfolio 👍

There’s a reason why the world of finance looks at portfolio diversification as one of the most secure strategies. When done correctly, a diversified portfolio gives you the peace of mind you need by minimizing the risk of loss and maximizing your profits without needing much intervention. 

By concentrating all your capital on a single income source, you’re depriving yourself of the opportunity to gain more from other assets as well as opening yourself up to a lot of vulnerability. If the asset you’re banking on is underperforming, you’ll be essentially losing your entire investment capital. But if your portfolio is split between multiple other securities, the loss wouldn’t affect you so much. 

Not only that, but you can tailor your portfolio to align with your financial goals and risk appetites. With regular rebalancing, you can tweak your portfolio to reflect where you are on your investment journey, i.e., be more conservative closer to retirement age or actively accumulate when you get a fat bonus from work.

A diversified portfolio would also give you more liquidity as you can shuffle your securities around as you go along. Besides being able to cut your losses and move on, you’d also be able to reinvest profits or re-allocate your assets according to market movements. 

Limitations of a Diversified Portfolio 🚫

Diversifying your portfolio is somewhat of a golden rule in the investment community, but that doesn’t mean it’s not without its downsides. For one, you might find yourself overwhelmed with the sheer amount of securities you own. It could also take a while to set up your ideal portfolio, as you’d need to see how each asset performs against the other. 

Diversification can also be very expensive as not all securities cost the same, i.e., bonds and REITs that have a much higher entry investment than penny stocks. Not only that, but you’d also need to bear the transaction fees and brokerage charges from the mistakes you make. 

One of the most common pitfalls that new investors face when diversifying their portfolios is over-diversification. By spreading your investment capital too thin, you risk filling your portfolio with underperforming stocks that stunt your portfolio’s earning potential. On the other end of the spectrum, investors that are unwilling to take risks might end up holding way too many bonds with meager returns. 

Bottom Line 🏁

Congratulations—you’ve made it to the end of the article! When it comes down to it, portfolio diversification is an essential investment strategy that every sensible investor must know. By allocating your assets wisely, you’re giving yourself a shield against unexpected losses and a better chance at coming out on top. 💪

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