Diversification is an investment risk management tool that involves allocating portions of a portfolio among different assets or asset classes.
The premise of diversification is two-pronged: the first part is that if a particular asset experiences poor performance, the portfolio’s loss will be limited to the amount invested in that asset. The second part is that the loss experienced by one asset will be offset by the performance of other assets – hopefully, keeping the portfolio “afloat”.
Diversification by Asset Class
The most common way to diversify a portfolio is by asset class. Individuals’ portfolios are commonly diversified among stocks and bonds. A portfolio diversified in this way could have 60% in stocks and 40% in bonds, for example.
More sophisticated investors commonly incorporate more obscure asset classes in their portfolios to diversify against certain risks. An investor fearing inflation may put 10% of their money into precious metals, for example, since this asset class thrives during times of inflation.
Investing abroad is another common way to diversify. If an investor thinks that factors relating to politics or currency in their own country may be problematic, they may choose to hold some of their money in stocks or bonds in other countries.
Diversification within Asset Classes
Even within one asset class, diversification can be achieved. Suppose an investor allocates 40% of their portfolio to stocks. Within that stock allocation, diversification could be achieved by putting 10% of the portfolio in large-cap stocks (for stable growth and liquidity), 20% in small-caps (for aggressive growth), and 10% in international stocks (to diversify against political risk).
Diversification within a portfolio of bonds could look like: 20% in municipal bonds, 40% in high-quality corporate bonds, 20% in treasuries, and 20% in high-yields.
Within a diversified portfolio, it is likely that some assets will grow at a faster rate than others. When this happens, the portfolio can lose its intended level of diversification, becoming overweight in some assets and underweight in others.
Consider, for example, a diversified portfolio of $100,000 with 40% allocated to stocks, 40% to bonds, and 20% to a real estate investment trust (REIT). A year later, the stocks have done well, having grown to $60,000. The bonds took a hit and are now worth $35,000 and the REIT is holding steady at approximately $20,000.
The good news is that the portfolio has grown to $115,000, but the desired diversification has been lost. The 40%/40%/20% is now 52%/30%/17%. You would need to do some trading, ending up with $46,000 in stocks, $46,000 in bonds, and $23,000 in REIT shares in order to restore the intended level of diversification.
This practice of buying and selling securities to reach a target allocation is known as portfolio rebalancing, and it is an important diversification strategy. Many financial professionals recommend rebalancing a portfolio on a regular periodic basis, such as once per year.
Diversification in Retirement Planning
Diversification is a popular tool in investing for retirement planning. De-risking a portfolio becomes more important as a person nears retirement, and diversification can be an effective way to de-risk. Many investors reduce exposure to equity securities and increase holdings of “safe” assets such as bonds as part of a retirement planning allocation.