Understanding how to diversify your portfolio properly starts with understanding the fundamentals of diversification and asking the right questions to figure out how to apply these principles to your personal portfolio in practical ways. In this article, we look at crucial questions
1. What is my risk tolerance?
Risk reduction is at the heart of diversification, and it’s used specifically to reduce unsystematic risk, also known as diversifiable risk. While exposure to unsystematic risk, or volatility, can be reduced by using a strong diversification strategy, it’s impossible to eliminate risk from any investment altogether. Therefore, before choosing investments to diversify your portfolio, it’s important to determine the amount of volatility that you’re comfortable taking on – or your risk tolerance.
2. What is my risk-adjusted rate of return?
Your goal as an investor is likely to maximize returns at your given level of risk. To do that, it’s important to understand how much risk you’re taking on, and the return potential that you’re receiving in exchange for taking on that risk.
In other words: How well are you being compensated for the risk that you’re taking on?
3. How many asset classes am I invested in?
It’s likely that you’re invested in more than one asset class, but do you know how many asset classes you’re invested in? Is your portfolio composed mostly or entirely of stocks and bonds, or have you branched out to other major asset classes? Most investors invest at least part of their portfolio in equity through stocks, and in fixed-income assets through bonds. But there are many investment options beyond those two asset classes.
Why is it important to diversify beyond stocks and bonds?
Investments have different traits at the company level, industry level, sector level, country level, and beyond, but the fundamental structure of assets is divisible at the asset class level. At the asset class level, investments can have different return structures and investment horizons, among other traits. By investing in securities across multiple asset classes, investors can reduce correlation within their portfolios – and ultimately volatility – in one of the most significant ways available. Obviously, the lower the volatility of a portfolio, the more stable it is.
4. What value does each asset class add to my portfolio?
The greatest diversification and risk reduction value is found in investing across asset classes with little or no correlation. Why? The performance of these investments share little to no relation to one another – positively or negatively. The less that prices of different investments move in unison, the more stable the returns of an overall portfolio are expected to be.
For example, if there’s a spike in oil prices, both an airline company and a car rental company share a risk of loss due to the fact that the profit potential of both companies depends on oil prices. Even though the market risks of an airline company and a car rental company aren’t the same, they are related, because they both rely upon some of the same inputs, including oil. If you own investments in both companies, both of those investments share a risk of being negatively affected in this scenario.
5. Am I diversified within each asset class that I’m invested in?
Investing in a diversified mixture of uncorrelated asset classes will enhance your portfolio diversification, but that diversification power is lowered – or lost – if investments are concentrated within each asset class. If you invest in only five different stocks and three different bonds, you have a high concentration of investments within each of those asset classes. If one of those investments experiences a loss, then your investment portfolio will likely be hit hard. But, if you invest in dozens or hundreds of investments within each asset class – with as little correlation between investments as possible – then you would have far more diversification both at the asset class level and the individual investment level.
6. How many markets am I invested in?
As you may have already learned from the above questions, the market in which an investment is traded impacts its diversification power. Markets can be categorized across many lines. They can be broken down by function such as capital markets, money markets, and derivative markets, among others. They can also be classified by new issue (first market) and the re-selling (second market) of investments, including primary, secondary, tertiary, and quaternary markets.
On top of intermarket dynamics, the shrinking public market, concentration of ownership of available investments, and the increased indexation of public investments have contributed to the reduction in the number of investments available to public investors as well as increased correlation among those investments. Due to these factors, investing solely in public market investments has limited diversification potential for investors.
The private market, in comparison, is far more inefficient with higher transactional friction. It’s also more fragmented rather than centralized with asymmetric information available to buyers and sellers. While the dynamics of the private market may seem undesirable for investors on the surface, its inefficiency actually offers a way for investors to “beat the market” – or earn alpha, because prices are not set by the market, but negotiated between buyers and sellers. In other words, investors who are well-informed or skillful may have an opportunity to earn above-market-rate returns.
7. How will my portfolio be impacted by inflation?
Unfortunately, earning an investment return doesn’t necessarily mean you’re getting ahead financially. That’s because, generally speaking, currency loses value each year due to inflation. This is why a dollar in 2019 doesn’t hold the same purchasing power as it did in 1919. Therefore, it’s important to ensure that your portfolio’s risk-adjusted earning power is maximized, so the growth of your wealth not only keeps pace with inflation, but surpasses it.
For example, if you earn a 5% annual return in a year when inflation rises 2%, your wealth could be growing at a slower pace than you may realize. Or, even worse, if your investment portfolio has a loss in a year when inflation rises 2%, your losses are automatically even worse.
8. Am I following a defined diversification strategy or am I just “diversifying”?
Far too often, investors make the mistake of believing that their portfolios are sufficiently diversified, because they own a variety of investments. But as you may have learned already, ownership of dozens or even hundreds of different investments doesn’t necessarily guarantee meaningful diversification. A strong diversification strategy must take correlation into account. Choosing investments with low or no correlation at several levels, as discussed, can reduce total portfolio correlation, and therefore risk of loss. That’s because – mathematically speaking – by diversifying into investments with low or no correlation, you can lower your overall portfolio volatility.