If you’re completely new to investing and looking for just one rule to guide your investment strategy, let it be this: Don’t put all your eggs in one basket. By building a well-diversified portfolio that holds multiple assets and asset classes, you’ll be better positioned to weather volatility and reduce the risk of losing all of your capital.
But if you are new to investing, you might still have a few questions. Such as: What is diversification, anyway, and how do you put it into practice?
Below we answer these and other common questions investors have about diversification, so that by the end you’ll be better equipped to make the right investment decisions for your personal financial situation.
What is diversification in investing?
Portfolio diversification refers to the practice of investing in different assets and asset classes in order to spread your risk around. As mentioned above, it’s the investment version of not putting all your eggs in one basket.
Portfolio diversification exists when the assets in an investment portfolio are not all highly correlated with one another.
When the assets of a portfolio are highly correlated with one another, they tend to move in the same direction at the same time. Where you might lose on one asset, you’ll likely lose on others as well. But for a diversified portfolio, on any given day, some of its assets will be up and some will be down. Where you might lose on one asset, you’ll likely gain on another.
Portfolio diversification, then, helps lower a portfolio’s volatility, which is just another way of saying that it lessens the fluctuations in a portfolio’s overall value. The end result is that investors are usually able to sleep better at night.
At this point you might be wondering what diversification looks like in practice. Well, diversification can take a number of different forms, and the right option for you will depend on your risk tolerance and circumstances.
Diversifying Across Asset Classes
When a portfolio is diversified across asset classes, what that means is that the portfolio holds a variety of types of investments—not just one.
So, instead of holding only stocks, a portfolio that is diversified across asset classes might have exposure to stocks, bonds, real estate, commodities, and digital assets, among others. The benefit? Even if one asset class performs badly over a given period of time, the investor has exposure to other asset classes that might be performing better.
Note: The exact percentage allocated to each asset class will of course depend on an investor’s investment goals (how much return she is hoping to achieve), investment timeline (how long before she needs to access the money), and her risk tolerance (how much risk and volatility she’s willing to accept).
Diversifying Within Asset Classes
Once you know the percentage of your portfolio that you’d like to dedicate to each asset class, it’s also prudent to ensure that you are diversifying within that asset class as well. After all, if you designate 60% of your portfolio to stocks but only hold a single company’s stock, you’re still very concentrated in a single investment.
With this in mind, you’d potentially want to hold multiple investments within each asset class. For example, you might diversify your stock holdings by:
Industry or Sector: Companies operate in specific industries or sectors of the economy. At times, the stock of certain sectors will perform better than others. Sometimes this movement will depend on the economic cycle; at other times, there is less logic to the movements. If you were to diversify by industry or sector, you would hold shares of companies from a number of different industries or sectors.
Market Capitalization: Companies are often categorized by their market capitalization or “market cap,” i.e., the total value of their outstanding shares as determined by the market. Companies can be large cap, mid cap, small cap, and even micro cap. Larger companies offer more stability, as they are better equipped to survive economic downturns, but smaller companies offer more opportunity for growth. Diversifying by market cap gives you exposure to both of these benefits.
Geography: Stocks of domestic, US-based companies often form the bulk of many investment portfolios, as they’ve performed strongly in recent decades. But it’s also possible to purchase shares of companies based in other countries. Because different countries experience their own economic cycles, diversifying by geography can help offer both stability and growth to your portfolio.
One of the easiest ways of diversifying—both within and across asset classes—is by buying a variety of low-cost exchange-traded funds (ETFs), which can immediately give you exposure to hundreds or even thousands of different assets.
Diversification and the 60/40 Portfolio
The traditional 60/40 investment portfolio, where 60% of the portfolio is held in stocks and 40% is held in bonds, is an easy-to-understand example of diversification.
But just because it’s easy to understand doesn’t necessarily mean it’s the best option for today’s investors. In fact, there’s been a lot of talk about the impending demise of the 60/40 portfolio, and while we won’t go so far as to say the 60/40 portfolio is dead, there are some clear concerns that investors should be aware of.
Among the most important of these concerns is the fact that in recent years we’ve been living through an abnormal period of U.S. equity outperformance. This means that U.S. stocks have cumulatively returned substantially more on an annualized basis than their historical norm—a fact that has many seasoned market observers predicting that the coming years will see U.S. equities underperform (in perhaps an equally dramatic fashion) in order to become more aligned with economic fundamentals.
If stocks have been the primary driver of investment returns in recent years, and stocks are expected to deliver subpar performance going forward, investors might have to turn to other asset classes for yield: Asset classes like real estate, commodities, digital assets, etc.
But while hedge funds and wealth managers have always had access to those non-traditional asset classes, the average, everyday investor typically hasn’t. Until now.
With Allio, investors have direct access to all of these asset classes—both traditional assets, such as stocks and bonds, as well as alternative investments like real estate and commodities.