One of the most effective ways to reduce investment risk is to diversify your assets – you’ve probably heard this time and again. DIVERSIFY, DIVERSIFY, DIVERSIFY…
While most people are familiar with the general concept of diversification, we’ve found there is often still some mystery around the term. We’d like to clarify this for you, and help you understand what it means to have a diversified portfolio.
What is diversification in investing?
Diversification is an investing strategy that spreads a portfolio across several different types of investments. The goal is to minimize the risk associated with allocating all of an investor’s savings to one investment.
For example, an investor with a portfolio consisting of just one stock or a heavy focus in a single sector is probably not diversified. On the other hand, a portfolio consisting of stocks in many differing sectors, different types of bonds, various hard assets, and diverse international investments would likely be diversified.
To simplify this concept, you can imagine a farmer who splits his fields between two crops – one that thrives with lots of rain and one that performs best during a drought. If the season is rainy, half of his crops perform well, and he has a decent harvest. If there is a drought, the other half of his crops perform well, and he still has a decent harvest. However, if he only had one crop, there would be a chance of heavy losses or gains. In this way, the farmer has diversified to protect himself from the uncertainty of the weather.
Why would an investor consider diversification?
An investor would consider diversification if they were averse to large swings in their portfolio value. Diversification reduces this risk by investing in assets that typically react in opposite ways to market events. The end result should be less volatility in the portfolio.
Consider this simplified example to illustrate the benefits of diversification. An investor has a portfolio consisting of all bank stocks. Interest rates fall and banks earn less from their loans. In turn, their stock prices decline. Because the investor is only invested in bank stocks, their entire portfolio value tumbles.
Conversely, consider another investor with half of their portfolio invested in bank stocks and the other half invested in companies that sell large products typically requiring financing. When interest rates fall, customers are more likely to purchase products with financing and higher sales lift the stock prices of the companies selling large products. In this case, half of the investor’s portfolio could rise following interest rate cuts and half could fall – leaving them with a steadier portfolio value.
This example relies on oversimplified concepts to illustrate the value of diversification. In reality, stocks may not react as anticipated to market factors like interest rate cuts. Additionally, diversification does not guarantee profits or protection from losses.
How to Diversify Your Portfolio
There are many ways to diversify your portfolio and the right method for you depends on your individual goals. Some of the most common options are to diversify by asset class, sector, and geography.
To diversify your portfolio by asset class, you would need to purchase securities that have a strong negative correlation. For example, stocks and bonds can have opposite reactions to certain market factors, so owning both can lower your overall portfolio risk.
If you have a stock portfolio, you can diversify within a specific sector, in different market sectors or in competing geographical regions. These companies could be in different industries or even in the same if they offer competitive products. To diversify your stock portfolio, you would need a strong understanding of all your potential investments and how they generally perform relative to the other investments you plan to own.
You can similarly diversify the bond portion of your portfolio by buying bonds from different issuers and of different maturities. Countries, companies, and even local governments issue bonds for various reasons, so there are many options to evaluate.
Diversifying your entire portfolio by geography often includes purchasing investments from companies or governments across the globe to dampen political risk. It is effective because investments are influenced by the actions of the government under which they operate. Therefore, if you purchase investments from several different countries, you can reduce the risk of one government action having disastrous consequences for your entire portfolio.
All these methods of diversification seek to do the same thing – stabilize the value of your portfolio. Luckily, financial professionals have developed a metric called Beta – which measures the volatility of an investment or a portfolio of investments relative to the market as a whole. A low Beta generally indicates a well-diversified portfolio. While these calculations might be too complex for you to complete on your own, your experienced investment advisor can help you calculate the Beta of your portfolio.
Downsides Of Diversification
As previously mentioned, diversification seeks to find balance between risk and reward in your portfolio. As such, by reducing risk you can also reduce the possibility of reward.
To circle back to a previous example, if an investor owns all bank stocks and that industry sees a boom, their entire portfolio could rise. On the other hand, if they own half bank stocks and half stocks of companies that sell large products, only half of their portfolio would have the potential to rise due to a boom in bank stocks.
The right mix of stocks and other investments for your portfolio should be based on your individual goals and your willingness to accept risk in order to achieve the possibility of profits. An experienced wealth manager can help you determine how to diversify your portfolio to reduce risk while maintaining your ability to profit from your investments.
Get A Diversified Portfolio from DreamWork Financial Group
At DreamWork Financial Group, we can help you create a well-diversified portfolio. Our innovative investing and wealth management program, Investing Gameplan™, includes a custom portfolio tailored to your individual goals and investing preferences.
Our individualized portfolios are comprised of an optimized mix of individual stocks and low-cost ETFs. Many investors believe this level of customization is only for the very wealthy, but with DreamWork You Don’t Have To Be Wealthy To Have Wealth Management®.
Contact us today to learn more and get started.