Diversification is often described as the only free lunch in investing. According to the Securities and Exchange Commission (SEC): “The practice of spreading money among different investments to reduce risk is known as diversification. By picking the right group of investments, you may be able to limit your losses and reduce the fluctuations of investment returns without sacrificing too much potential gain.” In this article, I will walk you through six essential steps to diversify your portfolio.
1. Know Your Risk Tolerance
Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional or spur-of-the-moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.
Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.
2. Understand Your Risk Capacity
Often your emotional willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. Or you could be way too conservative while you need to be a bit more aggressive. Factors like the size of savings and investment assets, investment horizon and financial goals will determine the individual risk capacity. (For related reading, see: Risk Tolerance Only Tells Half the Story.)
3. Set a Target Asset Allocation
Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.
These asset classes often include small-cap, deep value and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors with lower risk tolerance will look for safer investments like government and corporate bonds, dividends, and low volatility stocks.
In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historically low dependence on each other’s returns. The U.S. large cap stocks and U.S. Treasury bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. These two popular asset classes tend to move in opposite direction. U.S. Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets. (For related reading, see: Diversification: It's All About (Asset) Class.)
4. Reduce Your Concentrated Positions
There is a high chance you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account. If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401(k) plan matching, stock awards, stock options, inheritance, gifts or just personal investing.
The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a significant portion of your investments and retirement savings. Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they can sit on significant capital gains that can trigger large tax bills if sold. (For related reading, see: Solutions for Concentrated Positions.)
5. Rebalance Regularly
Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at different rates they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.
Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.
6. Focus on Your Long-Term Goals
When managing your portfolio, apply a balanced, disciplined, long-term approach that focuses on your long-term financial goals.
Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy, ignoring the fact they may not fit with our financial goals and risk tolerance.
If you are about to retire, you probably don’t want to put all your investments in a new biotech company or a tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And regularly taking risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.
Focusing on your long-term goals will let you endure through turbulent times and help your wealth and assets grow over time.
(For more from this author, see: 15 Mistakes People Make When Planning for Retirement.)
The content of this article is a sole view of the author and Babylon Wealth Management, fee-only registered investment advisor in the state of California. The opinion and information provided are only valid at the time of publishing of this article. The material contained in this article is provided solely for information purposes only and does not constitute investment, legal, or tax advice, nor is it an offer to sell or a solicitation to buy any investment, investment process, strategy, or advice. It has been prepared without regard to the individual circumstances and objectives of persons who read it and may not be suitable for all individuals. Babylon Wealth Management encourages individuals to seek the advice of a professional advisor. The appropriateness of the particular advice, investment, or another strategy depends on a person’s or entities individual or specific circumstances. Past performance does not guarantee future results. Various sources may provide different historical figures due to variations in methodology and timing.