Investment diversification is a portfolio that includes various assets that can earn the highest return with the least risk. In a diversified investment portfolio, there are typically a variety of stocks, fixed income, bonds, mutual funds, ETFs, commodities and more.
Effectively, diversification is spreading risk across different types of investments with the goal of increasing the odds of your investment success. When diversification is done well and broadly, it can produce long term returns along with protecting investments in volatile markets.
Key Takeaways about Investment Diversification
· Diversification helps manage risk
· You can choose a risk tolerance you can live with
· Rebalancing your investment portfolio is a key to managing and maintaining risk exposure over time
According to top Bay Area financial advisors, there are four vital keys to effective diversification that must be understood and effectively applied to ensure long term success:
1. Risk and Returns are Related
For long term investment performance, it is the deliberate assumption of risk that drives returns. The more risk you are willing to assume, the greater the returns you should expect. Portfolio diversification is the primary tool for managing risk. This is so it’s not concentrated in any one investment; rather, it is spread among different asset classes, which can reduce portfolio volatility and produce more stable returns over the long term.
The key to effective diversification is recognizing that different assets and all of the subsets of assets have varying ranges and patterns of volatility. For instance, equities as a whole are less volatile than any one subset of equities. It is through the higher volatility of some subsets of assets and the exposure to different patterns of volatility that higher returns are possible without increasing the standard deviation, or risk of your overall portfolio.
2. Asset Mix is Critical to Long Term Investment Returns
Central to any investment strategy, regardless of an investor’s risk comfort level, is the long-term mix of assets. Based primarily on the premise that not all assets move in concert, and some are more volatile than others, the purpose of asset allocation is to capture the benefits of diversification while investing in assets that have a low correlation to each other. The practice of asset allocation seeks to achieve the optimum mix of assets that will generate returns linked directly to your long-term investment objectives. Because of the fundamental economic relationship between risk and return, to an overwhelming degree, an investor’s selection of asset mix has the primary impact on that investor’s long-term investment returns.
3. U.S. Diversification vs. Global Diversification
If your portfolio is only diversified in U.S. markets, you expose your portfolio to more volatility and risk. Additionally, you most certainly miss the opportunities for returns that are available in the global markets. In any given year, foreign markets and their subsets of emerging economy markets, developed countries, and the various regional markets (i.e., Asia, Europe, South America, etc.), will perform contrary to one another and/or to the United States. Because it’s too difficult to identify which markets will outperform or fade, global diversification enables your portfolio to capture returns wherever they occur.
4. Avoid Under-diversification
Mutual fund managers are under tremendous pressure to outperform the indexes and show their investors that they are investing in “the winners.” This is why the vast majority of growth mutual funds own many of the same stocks. For example, Apple, which is one of the best performing stocks of the last five years, is a top holding in 45 percent of growth stock mutual funds. So, if you own four or five different growth stock mutual funds, chances are you have a great deal of exposure to Apple stock or any number of the more heavily traded stocks at the moment.
Since it is impossible to reliably identify winners before the fact, the most prudent approach is to maintain broad diversification and consistent exposure within various asset classes. When you have a portfolio that is properly diversified, it can capture returns whenever and wherever they occur while managing the risk-return tradeoff according to your risk profile. Because your portfolio values change, it would be important to review your portfolio annually to ensure it is maintaining the optimum level of diversification for your investment needs.
Keep this in mind when you’re investing…
Investing is an ongoing process that requires regular attention and adjustment. To keep your investments working for you, be sure to create a tailored investment plan along with monitoring and managing your plan.