One thing even new investors understand is the concept of diversification, or the blending of asset classes to reduce risk. But even with a well-diversified stock portfolio, an individual is still exposed to market risk (or systematic risk), which cannot be reduced by adding additional stocks. Below we discuss the principles of diversification and how investors can a build a truly diversified portfolio.
What Exactly Is Diversification?
Diversification works by spreading your investments among a variety of asset classes (such as stocks, bonds, cash, T-bills, real estate, etc.) that have a low correlation to each other. Low correlation reduces volatility. The assets rise and fall in price at different times and at different rates. A portfolio holding diversified assets helps to create more consistency and improve overall performance.
How Does Correlation Work?
Correlation is simple: If two asset classes are perfectly correlated, they are said to have a correlation of +1. This means they move in lockstep with each other, either up or down.
A completely random correlation—a relationship in which one asset's chance of rising is equal to the chance of it dropping if the other asset rises or falls—has a correlation of 0.
If two asset classes move in exact opposition—for every uptick in one asset there is an equal downtick in the other, and vice versa—they are negatively correlated, or have a correlation of -1.
Diversified Stock Portfolio vs. Diversified Portfolio of Assets
When we talk about the importance of diversification in a stock portfolio, we're referring to an investor's attempt to reduce exposure to unsystematic risk (i.e. company-specific risk) by investing in various companies across different sectors, industries or even countries.
When we discuss diversification among asset classes, the same concept applies, but over a broader range. By diversifying holdings across different asset classes, the investor reduces exposure to the systemic risk of any one asset class.
Like holding a single company in your stock portfolio, having your entire net worth in a portfolio of any one asset (even if that portfolio is diversified) constitutes "putting all of your eggs in one basket." You are still very much exposed to market risk. By investing in a broad number of assets, you reduce exposure to market risk or the systemic risk of any one asset class.
Although diversification is no guarantee against losses, investing professionals see this as a prudent long-range strategy.
How to Diversify Your Portfolio
Bonds are a popular way to diversify due to their low correlation with other major asset classes, particularly equities. Other fixed-interest investments such as T-bills, bankers' acceptances and certificates of deposit are also popular.
Another option is real estate, which has a relatively low correlation with stocks. Adding some real estate to your portfolio is a practical way to diversify, largely because many people (through home ownership) are invested in the real estate market.
It's amazing how often investors overlook the potential of real estate. Investing in real estate doesn't require the purchase a house or building. Real estate investment trusts (REITs) provide an easy and less expensive alternative to buying property directly. REITs trade like stocks on the major exchanges. They invest directly in property and mortgages and typically offer high yields. Because real estate has a relatively low correlation with stocks, investing in REITs is a good way to diversify away from equities.
The Bottom Line
Diversification is a key building block to anyone's financial plan, including understanding what diversification does and how it helps an individual's overall financial position. It is crucial that investors know the difference between systematic and unsystematic risk, as well as understand that by diversifying among asset classes, they can mitigate exposure to systematic risk.