Why Should You Diversify Your Investment Portfolio?

The U.S. equity markets had the worst first half since 1970, entering bear territory. And then, in July, equities turned in the best performance since November of 2020, recovering over 9%.

That can all be described by one word: volatility.

Market volatility has increased dramatically, and given the current high-inflation, rising rates environment; it's likely here to stay.

As an investor, how do you combat it? Also a one-word answer: diversification.

Portfolio diversification has been described as the "only free lunch in finance." Since the person doing the describing was the Nobel-prize winning economist who developed modern portfolio theory, it might actually be true.

But what is diversification? How do you get it, what does it do, and why?

Diversification Explained

Diversification isn’t an investment strategy. It’s a risk management strategy. The goal of a diversified portfolio is to achieve the highest possible return for a given measure of risk.

This is achieved by allocating assets to different asset classes. The principle is that different asset classes will respond uniquely to the same market environment. When one asset class struggles, other asset classes may outperform.

Taken together, portfolio diversification creates a smoothing of returns over time and higher returns for the overall portfolio.

Diversification Covers a Broad Landscape

Effectively diversifying an investment portfolio means looking across asset classes and within asset classes. Think of it as a series of ever-finely-tuned movements.

For example, stocks and bonds are usually negatively correlated, which simply means that when stocks are up, bonds are down, and vice-versa. This is because stocks are perceived as riskier investments than bonds. Investors are willing to take on more risk when the economic environment looks positive. They pull money from bonds, invest it in stocks, and bond prices fall. Investors move back into bonds when the economy seems less rosy and prices rise.

This is the theory behind the classic 60/40 portfolio for retirees. For younger investors, the portfolio can be skewed to 70+ percentage of equities, as market downturns have more time to recover before the money will be needed.

But it's possible to diversify further within the equity and bond asset classes.

Diversification Within Asset Classes

Let's take bonds first. Bonds are generally Treasuries issued by the U.S. government, Investment Grade corporates, and High Yield corporates. On the risk/return spectrum, Treasuries would have the lowest risk and return, and High Yield corporates would have the highest risk/return potential. A portfolio allocation might comprise all three sectors.

On the equity front, things are more complicated. Diversification covers:

Geographies – Domestic and International

Sectors – There are 11 industry sectors that respond differently to market cycles

Style – Growth vs. Value

Market Cap – Large, Mid, and Small Cap

To see diversification in action, let’s take the first category – geographies. We’ve already referenced how U.S. equities have performed so far this year. How are international stocks holding up in comparison? We looked at Trading Economics, a website that tracks stock markets around the globe.

As of August 4^th, Trading Economics reports that:

The United States Stock Market Index SPX (US500) returned -6.31% year-to-date.

The Norway Stock Market Index (Oslo Bors All Shares) returned 7.21%.

That's a pretty big swing. Including domestic and international stocks in your portfolio would mean that you would not fully participate in the ups and downs of each asset class. But you would benefit from the risk mitigation of holding both asset classes, and over time, the combined portfolio would potentially experience higher return.

The Bottom Line

There are a lot of tools available to create a portfolio that matches an investor's individual risk tolerance, time horizon, and investment goals. Diversification is the first line of defense because asset allocation is generally more durable. Your asset allocation should be diversified along your chosen asset classes and matched to a long-term horizon. As market cycles change and economic conditions evolve, assets will rise and fall in value. The portfolio can be tuned up to bring it back in line with the original risk tolerance. This keeps the portfolio fully diversified and prevents an overweighting of asset classes.

Investors who take a broad view of their portfolios are able to access the most tools and will likely see the most benefit from diversifying their portfolios.

The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but are intended to help manage risk and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax or financial advice. Please consult a legal, tax or financial professional for information specific to your individual situation.

This content not reviewed by FINRA