Diversification in investing may reduce risk

Markets and Investing

 

The long economic expansion has led many investors to settle into a state of optimism. 

“Investors may be overconfident, and they don’t think they need to insure themselves against risk,” says Rob Haworth, senior vice president and senior investment strategist for U.S. Bank.

Diversification is important in investing because it can help mitigate the risks that uncertainty creates. But many investors believe their portfolios are more diversified than they actually are.

Although risk increases and decreases over time based on a number of factors, it never disappears. One way to potentially protect your portfolio? Improve your diversification strategies.  

Understand sources of risk

Before you look to improve diversification in your portfolio, consider the common sources of uncertainty and volatility:

  • Interest rates: Higher rates have increased the returns on bonds, which has made them a more attractive investment. Investors have responded by shifting into bonds, sometimes selling off stocks in the process. “Overall, risks are now more balanced between stocks and bonds,” Haworth says. “But volatility in equity markets has increased.”
  • Corporate earnings: Another source of volatility, particularly for equity markets, is the future of corporate earnings. Investors have already priced the positive effects of the tax cuts into their beliefs about earnings. “That left investors at ‘peak price,’” Haworth explains. “Investors are now less clear about the earnings trajectory going forward. Growth looks good, but there is some uncertainty.”  
  • Trade: Fluctuating trade policy also raises questions about the future. In general, policy appears to be shifting from multilateral agreements to bilateral agreements, which Haworth sees as less certain. And, until new agreements are signed, markets cannot confidently assess the impacts on industries or individual companies. “Indicators of economic growth from key regions don’t align,” Haworth says. Three of the world’s major central banks — the U.S. Federal Reserve (the Fed), the European Central Bank (ECB) and the Bank of Japan (BoJ) — are implementing different interest rate policies. While the Fed is raising rates, the ECB and BoJ have held their rates at low levels since 2016. As a result, some investors are wondering whether the ECB and BoJ will soon change course.  

Mitigate risks with diversification

Diversification is important in investing because it can help mitigate the risks that uncertainty creates. But many investors believe their portfolios are more diversified than they actually are. For example, investors may have both stocks and bonds, which gives them diversity in asset classes. However, if an investor’s stocks are concentrated in a small number of industries, risk increases.

Haworth recommends these diversification strategies, if appropriate for your situation, to potentially mitigate the risks to your investments: 

  • Own assets in different industries: “Let’s say you happen to own a lot of a technology company,” he says. “You really need a diversified exposure around that.” Why? Because the technology industry behaves differently than other industries — such as energy, healthcare, financial services or consumer staples — under different economic conditions. If the economy slows, technology and luxury stocks tend to decline, while consumer staples stocks tend to hold steady because of consistent demand. If the economy expands, the financial services industry often benefits. True diversity comes from owning assets that have the potential to provide different payoffs under different economic conditions.
  • Invest in foreign markets: U.S. markets comprise about half of the global stock market in terms of value, so international markets offer another way to diversify the stock portion of a portfolio. Just as the returns of one industry typically differ from those of other industries depending on the state of the economy, global markets’ returns often differ from those of the U.S., Haworth explains. In addition, the top company in some global industries is based outside the U.S., which means investors who own only American companies could be missing opportunities for both diversification and growth.  
  • Diversify stock and bond allocations: Some investors own a substantial amount of stock in a single company. This often occurs if they’ve worked for a company for a long time and the company offers an employee stock purchase plan or stock options. Sometimes, members of a family own a large number of shares in a single company due to familiarity. It’s important to have diversity in not just the stock portion of a portfolio but also the bond allocation. In fact, according to Haworth, high-yielding, low-quality bonds often behave like stocks and therefore don’t effectively balance the risks associated with equity ownership. Investors should consider holding a sufficient share of their bond portfolio in high-quality bonds in order to achieve true diversity and balance risk and return. 

A financial professional can help provide necessary perspective and insight into how volatility may impact your portfolio over time and what diversification strategies make most sense for you.

For more perspective on the market, read our weekly market update 

 

Diversification and asset allocation do not guarantee returns or protection against losses.

Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic 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.