When it comes to investing, diversification is one of the most important strategies to reduce risk and optimize returns. But what exactly is diversification, and how can you apply it effectively? This guide breaks down the dos and don’ts when building a diversified portfolio.
Spread Out Your Assets
The core principle of diversification is not to put all your eggs in one basket. By investing in multiple asset classes and market sectors, you minimize exposure to volatility associated with any single investment. Ideally, you want to include a healthy mix of stocks, bonds, real estate, commodities, and cash.
Within stocks, further diversify across market caps, sectors, and geographic regions. Bond portfolios should contain a blend of government and corporate bonds with varying maturities. The broader you diversify, the more insulated your portfolio will be during downturns in particular markets.
Regular Rebalancing is Crucial
Over time, market performance will skew the target allocations in your portfolio. Rebalancing involves periodically buying and selling assets to restore your original desired asset allocation. This forces you to sell high and buy low, maintaining diversification versus chasing performance. Aim to rebalance at least once a year or when allocations sway more than 5-10% from targets.
While diversification is important for mitigating risk, overdiversifying can hamper returns. If you over-slice your portfolio into too many narrow positions, costs and friction will drag down performance. Try to find the optimal balance between adequate diversification and enough concentration to still benefit from your best ideas.
Pay attention to how different assets and markets correlate and move in relation to each other. Blending investments with low or negative correlations provides the most beneficial diversification. For example, Treasuries often move opposite to stocks, helping balance risk during equity downturns. Avoid allocating heavily to multiple assets with high positive correlations.
Diversify Beyond Investments
Diversification principles can apply more broadly to managing overall risk. Consider diversifying your income streams between multiple jobs, clients, or business ventures. Geographic diversification by living in different cities over your lifetime can mitigate location-specific risks. Even diversifying your skill set makes you more resilient to disruption.
Don’t Neglect Due Diligence
Diversification isn’t an excuse for poor investment selection. You still need rigorous due diligence for each asset class and investment you choose. Ensure you look into the real interest rate definition to understand the nominal interest rate minus inflation for your ideal investment. For example, if you get a 5% return on a bond, but inflation is 3%, the real return is only 2%. Watching real interest rates is vital for determining actual returns adjusted for purchasing power.
In addition, never buy into vague asset “baskets” without researching exactly what you are getting. Careful upfront evaluation allows you to identify and avoid outright losers.
Manage Emotions with Discipline
Emotional decision-making is the enemy of diversification. Guard against overriding your strategy by chasing short-term trends or dramatically shifting allocations. Have the discipline to rebalance methodically back to targets, even when it seems counterintuitive. Consistent discipline will lead to long-term results.
Don’t Forget About Alternatives
While stocks and bonds make up the core of most portfolios, alternative investments can provide further diversification benefits. Assets like commodities, currencies, private equity, hedge funds, and real estate tend to have lower correlations to traditional markets. Adding a small allocation to alternatives can enhance diversification during periods of stock and bond volatility. Just be wary of higher fees with some alt assets and the due diligence requirements.
In summary, diversification allows investors to maximize returns for a given level of risk. By distributing your portfolio across multiple assets and markets, you smooth out volatility and avoid catastrophic losses. Rebalance regularly, pay attention to correlations and diligently vet each investment. With the right diversification plan implemented with discipline, you can build resilience into your investing strategy.