For investors, one of the most important considerations is how to manage portfolio risk.
Diversification is the practice of building a portfolio with a variety of investments that have different expected risks and returns.
The benefit of diversification in your investment portfolio
Diversification can help protect you against events that would affect specific investments.
As an example, let’s look at industry-specific risk found in energy stocks. If the price of oil falls, it’s possible that multiple corporations that work in gas and oil may see their share prices fall. If you’ve invested in industries aside from energy, that decline in value would likely have less of an impact on your portfolio.
Diversification does not guarantee returns or protect against losses and can help mitigate some, but not all, risk. For example, systematic risks – which include inflation, interest rates or geopolitical events – can cause instability in markets and affect the broader economy and market overall.
Here are 7 strategies you can use to diversify your portfolio.
1. Determine correlation
It’s important to consider the correlation between the investments in your portfolio.
Even if you own many different investments, if they all trend up or down together, your portfolio isn’t appropriately diversified. For instance, high-yield bonds often have a positive correlation with stocks. Therefore, a portfolio made up entirely of high-yield bonds and stocks is not well diversified.
2. Diversify across asset classes
Investing offers several asset classes to choose from, including:
- Equities (stocks)
- Fixed income investments (bonds)
- Cash and cash equivalents
- Real assets including property and commodities
These asset classes have varying levels of risk and returns, so including investments across asset classes will help you create a diversified portfolio. Diversified investment portfolios generally contain at least two asset classes.
3. Diversity within asset classes
Following are a few ways to diversify within an asset class.
- Industry. If you invest in energy stocks, for instance, consider adding tech, biotech, utility, retail, and other sectors to your portfolio.
- Fixed income investments (bonds). Look for bonds with different maturities and from different issuers, including the U.S. government and corporations.
- Funds. While some funds track the overall stock market (known as index funds), other funds focus on specific segments of the stock market. If your goal is diversification, check what stocks your funds invest in to make sure you’re not overly exposed to one area or another.
4. Diversify by location
Asset classes aren’t the only way to diversify. It’s a good idea to consider location and global exposure.
For example, if you only own U.S. securities, your entire portfolio is subject to U.S.-specific risk. Foreign stocks and bonds can increase a portfolio’s diversification but are subject to country-specific risks, such as foreign taxation, currency risks, and risks associated with political and economic development.
5. Explore alternative investments
If you’re seeking additional diversification, assets such as real estate investment trusts (REITs) and commodities are potential options.
- A REIT owns and operates properties, such as office buildings, shopping centers or apartment buildings. Owning shares in a REIT gives you the chance to receive a portion of the earnings of those businesses in dividends. Additionally, REITs are not strongly correlated with stocks or bonds.
- Commodity investments are investments in physical goods, from gold to natural gas to wheat and even cattle. You can buy commodities directly or through a commodity fund.
6. Rebalance your portfolio regularly
Even the most diversified portfolio needs to be rebalanced. Over time, certain investments will gain value, while others lose it. Rebalancing is a negotiation between risk and reward that can help your portfolio stay on track amidst the market highs and lows.
There are certain situations that might trigger rebalancing, including market volatility and major life events. Read more about when to rebalance your portfolio.
7. Consider your risk tolerance
Your tolerance for risk can impact your approach to diversification. Generally, the longer your timeframe, the more you can weather short-term losses for the potential to capture long-term gains.
- Aggressive investors generally have time horizons of 30 or more years. With this flexibility, they have a higher risk tolerance and may allocate 90 percent of their money to stocks and just 10 percent to bonds.
- Moderate investors, who have approximately 20 years before they need their money, generally allocate a lower percentage to stocks than an aggressive investor. For example, they may have 70 percent of their funds in stock and 30 percent in bonds.
- Conservative investors — those who have little risk tolerance or will need their money in 10 or fewer years — may do a 50/50 balance between stocks and bonds.
These five questions can help you determine your risk tolerance.
REITS and commodities are examples of investments that can help diversify your portfolio. Read more about alternative investments.
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. Investments in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Investment in fixed income securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term securities. Investments in lower-rated and non-rated securities present a greater risk of loss to principal and interest than higher-rated securities. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Investments in real estate securities can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate values, changes in interest rates and risks related to renting properties (such as rental defaults).