Are You Truly Diversified?

December 9, 2021

It’s the golden mantra of investing: diversify, diversify, diversify. But there’s a chance you may not be diversifying correctly.

In fact, only one third of Americans successfully diversify their investments.

Are you truly diversified? And if not, how do you achieve portfolio diversification? Here’s what investors should know.

What is Portfolio Diversification?

In investing, diversification is the practice of spreading your investments among several different types of assets. That way, your risk exposure to any one asset is limited, thus reducing your overall investment risk.

Think of it this way.

Let’s say you invest in just one company. The company is doing well, so you’re fairly confident in your investment. But then, the company turns out to not be as strong as you thought, and stock prices dive. Just like that, your whole investment is gone. But if you spread your investment among multiple companies, this reduces your overall losses, since your entire portfolio isn’t tied up in one place.

However, this also applies to investing in a single asset class, like stocks. Even if you invest broadly across the stock market, if the stock market takes a hit, your whole portfolio will suffer. This is why financial advisors recommend spreading your portfolio among multiple different asset types, including assets that don’t move in parallel with the stock market. That way, you’re not gambling with your entire portfolio when the stock market gets ugly.

The Four Components of a Diversified Portfolio

Fidelity identifies four basic components of a diversified portfolio:

  1. Stocks
  2. Bonds
  3. Short-term investments
  4. International stocks

Stocks are your growth vehicle and are quite easy to buy and sell, which is why they’re the foundation of almost every individual portfolio. Bonds, by comparison, are your safety net. You don’t get high returns on them, but you can count on them to return a specific amount of money. Short-term investments offer slightly higher returns, but they’re still a safe investment overall. International stocks are designed to distribute your risk among multiple economic markets. That way, if one country takes a turn for the worse, your whole portfolio won’t suffer the consequences.

That said, there are several other elements that go into a well-diversified portfolio. Alternative investments, for example, are any type of investment that isn’t a stock, bond, or cash, with the critical advantage of moving opposite the stock market. For this reason, many investors turn to alternatives as a store of value and a way to grow their money without relying on the typical market indicators.

The 60/40 Portfolio

Of course, knowing you need a diversified portfolio and knowing how to distribute your assets are two different things.

Remember, diversification isn’t just a safety net. It’s also a growth tool, and how you diversify can affect how much your portfolio grows. For example, if half of your portfolio is in safe investments like bonds with very low returns, you won’t achieve much growth. That’s fine for older investors close to retirement, who need their money protected. But for younger investors, who need to take advantage of growth for as long as possible, it’s the investing equivalent of kneecapping yourself.

It’s also important to remember that different investments have different risk levels. If you distribute investments evenly among risky assets, diversification may not help you—you don’t have enough safe investments to recoup major losses.

So, how should you distribute your assets for proper diversification? That actually depends on your age.

Basically, the younger you are, the more time you have to recover losses. This means that you have more time to recover losses. In a traditional asset allocation, for example, a young investor might use the 60/40 rule: 60% stocks and 40% bonds. Investors in their twenties might go as high as 70/30. However, this rule has become increasingly outdated as investors recognize that there are other investment options beyond stocks and the rule doesn’t fully account for risk and reward.

A smarter approach is to weight asset allocation based on risk and reward, with a greater allowance for risk based on age and when you need the money (tempered by your risk tolerance).

Naïve vs. Optimal Diversification

It’s also important to remember that there’s a huge difference between naïve diversification and optimal diversification.

Naïve diversification is a common mistake among inexperienced investors. This is when you choose securities at random, hoping that they reduce your risk overall. When dictated by experience, careful examination, and common sense, the method can reduce your risk overall, but it isn’t a sophisticated technique.

The better option is optimal diversification, also known as Markowitz diversification. This is a more sophisticated approach that focuses on finding assets whose correlation is not perfectly positive. That way, you better your statistical odds of reducing risk across your whole portfolio.

Your Tools for a Diversified Portfolio

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