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Diversification – What Is It and Why You Need It

Published April 23, 2021

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Budgeting & Goals
Financial Planning
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Don’t put all your eggs into one basket. That’s the idea behind diversification. Get a bunch of different baskets and spread your eggs between them. Diversification is a way to reduce risk in your investment portfolio by mitigating losses. So, if you drop one of your baskets and the eggs break, you still have all of your other eggs. You can diversify within asset classes, across asset classes, and geographically.

Diversification within an asset class

Let’s look at equities to see how to diversify within an asset class. Investing in equities involves two types of risk: systematic and unsystematic. Systematic risk is another word for market risk, which is the risk inherent in making any equity investment. Systematic risk cannot be diversified away but unsystematic risk can. Unsystematic risk is the risk of loss in any individual security or industry. By making a number of different equity investments, you can reduce unsystematic risk.

A popular way to invest in equities is through the S&P 500, a major equity index that is representative of the U.S. economy as a whole. The “500” are the 500 companies that compose the index, which is broken down into 11 sectors and 69 industries. You can invest in an S&P 500 equity index fund that will give you exposure to these different industries and sectors. This will reduce your overall portfolio risk because you’re reducing unsystematic risk

The mechanics of how this happens is as follows: Different industries typically outperform as we move through the different stages of an economic cycle (expansion, peak, contraction, trough). For example, healthcare typically thrives during contractions (also known as recessions), while financials do well in the expansion stage. Diversifying your investments across different industry sectors will give your portfolio some protection from changes in the economy because as one sector declines, another will likely be on the rise.

Individual companies will also perform differently depending on the nature of their business, where they are in their growth cycle, competition, and other factors. Hence, investing in a basket of equities is a way to reduce the risk any one company might pose to your portfolio.

Diversification across asset classes

Although investing in an equity index fund is a good start, it does not solve for all your portfolio diversification needs. While it provides diversification across equities and across sectors, it does not provide diversification across asset classes, which you can do by also investing in fixed income, real estate, commodities, private equity, venture capital, and more.

The correlation of asset classes varies, meaning the degree to which they move in concert varies. Correlation is expressed as a number from –1 to +1. A positive correlation means they move in the same direction, and a negative correlation means they move in opposite directions. Mixing together asset classes that have a low or negative correlation to each other helps improve the diversification of your portfolio because it reduces the portfolio’s overall volatility – as one asset moves up, another asset that has a low correlation to it should move down, balancing each other out to some degree. For example, U.S. Intermediate Treasuries have a -0.48 correlation to Private Equity,[1] meaning that if Treasuries increase by 1%, then Private Equity should decline by 0.48%. Note: correlations can, and do, change over time.

Geographic diversification

Finally, you can also diversify geographically. Typically, investments by geography are classified by different geographic regions: U.S., Europe, Asia, and Emerging markets (i.e. the rest of the world). You can spread out your investments in different geographic areas with the thought that if say the economy in the U.S. is in a recession, economic conditions in Asia or elsewhere may be in better shape.

Putting it all together

You can achieve diversification in your investment portfolio by investing in different securities, different sectors, different asset classes and different geographies. A basic portfolio might include a combination of equities and fixed income. The exact percentage will be informed by your risk tolerance. To keep it simple, you can invest in an equity index fund like the SPDR ETF (S&P 500 index) and a fixed income index fund like a total bond fund. The next step up might be to invest in some small and midcap companies, as well as an international ETF, in your equity portfolio, and invest the rest in fixed income. You can get as complicated as you want, selecting individual equities and individual bonds, as well as additional asset classes, but as the complexity increases, so does the time and effort involved.

Diversifying your portfolio is an ongoing process. As time passes, your investments will fluctuate and need to be rebalanced, perhaps quarterly or annually, to maintain the diversification levels you’re seeking.

The goal of diversification is to reduce the risk in your investment portfolio so that you can absorb the occasional setback you will invariably experience as an investor. A properly diversified portfolio, combined with prudent investment choices, will set you on the path to achieving your investment goals.

 

[1] https://am.jpmorgan.com/us/en/asset-management/institutional/insights/portfolio-insights/ltcma/interactive-assumptions-matrices/

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