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 build a truly diversified portfolio.
- A well-diversified portfolio can mitigate the exposure to market risk.
- Diversification works by spreading your investments among a variety of asset classes: stocks, bonds, cash, T-bills, real estate, precious metals, etc.
- The different assets should have a low correlation to each other, meaning they move in exact opposition.
- Investing fully in stocks is considered riskier than a portfolio with a more diversified set of asset classes, since it can be hit incredibly hard by a market crash.
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, and based on a variety of factors. 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. A diversified stock portfolio contains a broad variety of stocks, but it is still focused on that single asset class.
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. Thus, if a market crash sends all of the prices of the stocks in the portfolio tumbling, other uncorrelated assets may not lose value at the same time, providing additional stability.
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. Investors typically view these asset classes as less prone to risk compared with stocks. Conversely, they may also provide lower returns.
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 homeownership) 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 of 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.
Safe Haven Assets
So-called safe-haven assets are those specifically utilized to provide stability to a portfolio during times of market turmoil. While some of the assets listed above can be safe havens, the iconic safe-haven asset is gold. Gold (and other precious metals) are stores of value that are not subject to issues related to interest rates. Although some investors may debate the value of gold as a safe haven, historically it has tended to maintain its value over time. This means it can be a hedge against inflation and adverse market conditions.
Currencies can be an important part of a diversification strategy. Cash is in some ways the ultimate safe-haven asset. However, it is generally not advisable to hold cash over a long period, as it provides little by way of yield or return and is negatively impacted by inflation.
How Many Stocks Does It Take to Diversify a Portfolio?
There is no hard-and-fixed number of stocks to diversify a portfolio. Generally, a portfolio with a greater number of stocks is more diverse. However, some things to keep in mind which may impact diversification include the fact that the qualities of the stocks (including their sectors, the size, and strength of the company, etc.) have an impact. Additionally, stock portfolios are generally still subject to market risk, so diversifying into other asset classes may be preferable to increasing the size of a stock portfolio.
Is It Possible to Overdiversify a Portfolio?
It is. A portfolio becomes over-diversified if an investment added to the portfolio lowers the expected return more than it lowers the risk profile. In this case, the portfolio is not best able to capture returns given its risk considerations.
Should You Be 100% Invested in Stocks?
Investing fully in stocks is generally considered riskier than a portfolio with a more diversified set of asset classes. The reason for this is that an all-stock portfolio can be hit incredibly hard by a market crash. By adding other asset classes, including bonds, T-bills, real estate, or precious metals to a portfolio, you can limit this risk.
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.