One of the fundamental principles of successful investing is diversification. Diversifying your investment portfolio can help mitigate risk and increase your chances of long-term wealth accumulation.
What is diversification in investing?
Diversification in investing refers to spreading your investments across different assets or asset classes to reduce risk. The basic principle behind diversification is that not all investments perform the same way at the same time. By diversifying your portfolio, you minimize the impact of poor performance of any one investment on your overall portfolio.
Limitations of diversification
While diversification has benefits, it also has limitations:
- Market-wide risks: Diversification can help reduce risks associated with individual investments but does not eliminate market-wide risks. Economic recessions, geopolitical events, or systemic risks can affect the entire market, leading to losses across a diversified portfolio.
- Correlation and systemic risks: Diversification assumes the assets in a portfolio have low or negative correlations. However, during times of extreme market stress or systemic events, correlations between different asset classes can increase, reducing the effectiveness of diversification. For example, while the returns of stocks and bonds historically have a negative correlation, both produced negative absolute returns in the first half of 2022. Investors who thought holding these two asset classes protected them from losses were disappointed.
- Over-diversification: While diversification is generally beneficial, it’s possible to over-diversify a portfolio. Over-diversification can lead to diluted returns because spreading investments too thin may limit the potential for significant gains from individual investments.
- Opportunity costs: By diversifying across multiple assets or asset classes, investors may miss out on the potential for higher returns in a concentrated portfolio. When a particular investment performs exceptionally well, a diversified portfolio may not fully capture its gains.
How to diversify your portfolio
Here are some basic principles to follow when diversifying your portfolio:
- Asset allocation: Allocate your investments across different asset classes like stocks, bonds, cash, real estate, and commodities. Each asset class has risk and return characteristics, so diversifying across them can help balance your portfolio.
- Sector diversification: Invest in different sectors or industries, like technology, healthcare, finance, and consumer goods. This strategy helps reduce the risk of being heavily exposed to a single sector.
- Geographic diversification: Invest in assets across different countries or regions. Economic conditions, political events, and market cycles can vary from one region to another, so having exposure to other geographical areas can mitigate the risk associated with exposure to a single country.
- Company Size Diversification: Allocate investments across companies of different market capitalizations, like large-cap, mid-cap, and small-cap stocks. Each category has its own risk and growth potential; diversifying across them can balance your exposure.
- Time Diversification: Investing systematically over a period of time, known as dollar-cost averaging, can reduce the impact of short-term market fluctuations.
How to implement a diversification strategy
Index funds, ETFs (Exchange-Traded Funds), and passively managed funds, like those offered by Dimensional Fund Advisors, are popular investment vehicles that can effectively diversify a portfolio.
- Broad market exposure: Index funds, ETFs, and passively managed funds typically aim to replicate the performance of a specific market index or a broad market segment. Investing in these funds exposes you to a wide range of securities within the index or segment, providing instant diversification across multiple companies and sectors.
- Cost efficiency: These funds often have lower expense ratios than actively managed funds. Since they aim to track an index rather than relying on active stock picking, the costs associated with research, trading, and portfolio management are generally lower. This cost efficiency can help maximize returns over the long term, especially when compounded over time.
- Reduced managerial risk: Active fund managers attempt to outperform the market by making specific investment decisions. However, most actively managed funds underperform their benchmarks, especially over the long term and after taxes, due to human error, high fees, or inconsistent performance.
Index funds and passively managed funds eliminate the risk of underperformance due to manager decisions because they track the performance of the underlying index.
While index funds, ETFs, and passively managed funds offer diversification benefits, they are not risk-free. Their performance is tied to the performance of the underlying index, and they are subject to market volatility and fluctuation.
Should you hire a financial advisor
to diversify your portfolio?
Hiring a financial advisor can provide several benefits when diversifying your investment portfolio. Here are some of the key advantages:
- Expertise and knowledge: Financial advisors have experience navigating the complexities of the financial markets.
- Personalized approach: A financial advisor can provide customized advice based on your specific financial situation, goals, risk tolerance, and time horizon. They will consider your income, expenses, assets, liabilities, and tax to develop a customized investment plan that aligns with your objectives.
- Risk management: Diversifying a portfolio is primarily about managing risk. A financial advisor can help assess your risk tolerance and implement a diversified investment strategy that balances risk and potential returns. They can guide you in selecting the appropriate asset allocation, diversifying across different asset classes, and periodically rebalancing your portfolio.
- Behavioral coaching: One of the critical roles of a financial advisor is to provide behavioral coaching. A financial advisor can help you stay focused on your long-term goals, avoid emotional biases, and stick to your diversified investment plan.
- Ongoing monitoring and adjustments: Markets and investment landscapes change over time. A financial advisor can monitor your portfolio and recommend adjustments.
- Comprehensive financial planning: A financial advisor can offer more than just investment advice. They can assist you with comprehensive financial planning, including retirement planning, tax planning, estate planning, insurance needs, and other aspects of your financial life. A financial advisor can integrate portfolio diversification with your broader financial goals by considering your overall financial situation.
Choosing a reputable and qualified financial advisor who acts in your best interest is important. Look for registered investment advisors (RIAs) with relevant certifications (like Certified Financial Planner™ or Chartered Financial Analyst®) and consider their experience, reputation, and fees before deciding. Ultimately, the decision to hire a financial advisor should consider your circumstances, financial goals, and comfort level with managing your investments. Weigh the potential benefits against the associated costs and consider whether the expertise and guidance of a financial advisor align with your needs.