Diversification is an investment strategy that involves investing in a variety of asset types to reduce risks. It’s a way to act according to the famous saying “don’t put all your eggs in one basket.” It’s not enough just to own a collection of stocks. To build a diversified portfolio, you need to invest in multiple sectors of the stock market, as well as other asset classes like bonds and cash equivalents.
What is Portfolio Diversification?
Portfolio diversification is a long-term strategy that involves distributing funds across a wide range of assets to reduce the risks of fluctuations. However, diversification is not just about the number of investments you own.
It’s important to invest in multiple types of assets, such as stocks, bonds, and cash equivalents, including certificates of deposit and money market funds.
To understand how diversification works, let’s take an example of investing in stocks only. Suppose you invest $100,000 in just one stock during a year when you expect the stock market to generate returns of 8%. As a result of this decision, you can expect to lose between 80% and gain up to 96%, according to analysis by Edward Jones.
If you were to invest in 15 stocks over the same period, you would significantly reduce the range of potential outcomes. By diversifying with 15 stocks, you could expect to lose between 3% and profit up to 19%. Although your potential returns would be lower, you would significantly reduce the risk of losing most of your money.
Why Does Diversification Matter?
Having a portfolio that is overly concentrated in any one investment increases risk if that investment fails. Having a portfolio that is heavily concentrated in your employer’s stock is a classic example. Along with the risk of a declining stock market, there’s the risk of your company’s failure. In this scenario, the risk is twofold: a large portion of your investments would become worthless at the same time you lose your job, as happened to former employees of Lehman Brothers and Enron.
To achieve diversification, you need to do more than just invest in many different stocks alone. In fact, you want to own:
- Asset diversification: a mix of stocks, bonds, cash equivalents, and possibly alternative investments.
- Sector diversification: investments across 11 different sectors of the stock market.
- Geographic diversification: both domestic and international investments.
- Time diversification: a mix of investments that allows for multiple outcomes over a long period of time.
The Three Core Asset Classes
There are three main asset classes that should be included in a diversified portfolio:
- Stocks: Also known as “equities.” Stocks represent an ownership stake in a publicly traded company. You can earn money through appreciation in value or if the company pays dividends. Returns are not guaranteed, so you can lose money if the stock price declines. You can also invest in many different stocks through a mutual fund or an exchange-traded fund (ETF).
- Bonds: These securities are issued by companies or governments seeking to raise money. Investors typically earn profits from regular cash payments and receive their principal back when the bond matures. Bonds tend to offer lower risks but also lower returns than stocks.
- Cash equivalents: This category represents cash and short-term deposits. They carry extremely low risk but offer much lower returns than stocks and bonds. They are a good option for short-term needs.
It is important to note that diversification cannot eliminate systemic risks or threats related to your portfolio tied to the overall economy.
Using Alternatives in Diversification
Some investors seek to diversify beyond traditional asset classes. Adding alternative investments like real estate, commodities, or cryptocurrencies can provide additional diversification.
Risks
Over-Diversification
There is also a danger in over-diversification. Over-diversification occurs when you spread your money across many different investments to the point that it reduces your returns without significantly lowering your risks. Excessive diversification can make it difficult to track your investments and may lead you to invest in things you don’t understand. It can also lead to higher fees, especially if your portfolio is professionally managed.
One common mistake in over-diversification is investing in overlapping assets. Suppose you own an S&P 500 index fund. You want to diversify away from the S&P 500, so you add a total stock market fund to gain exposure to the entire U.S. stock market. You won’t get much additional diversification by holding both, because S&P 500 stocks represent about 80% of the U.S. stock market by market capitalization.
How Much Diversification is Enough?
There is no magic formula to determine how much diversification is enough. You could own hundreds of stocks but still not be properly diversified if they are concentrated in just one or two sectors. Here are some general guidelines:
How Many Stocks Should You Own?
Benjamin Graham, the father of value investing and mentor to Warren Buffett, recommended owning at least 40 stocks. However, modern recommendations vary based on how much of your portfolio is made up of individual stocks. This is because it is now possible to achieve diversification through mutual funds and exchange-traded funds.
As a rule of thumb, you don’t want any single investment to represent more than 5% of your portfolio. Note that this does not apply to mutual funds and exchange-traded funds, as they can include hundreds or even thousands of investments.
How Many Mutual Funds Should You Own?
You can often achieve sufficient diversification using just one target-date fund (TDF), a type of mutual fund commonly found in 401(k) plans. A target-date fund provides a mix of stocks and bonds that is allocated according to the investor’s planned retirement date. They start with a heavier focus on equities and then shift more towards bonds as your retirement date approaches.
Alternatively, you can diversify your investments by owning just three funds: a total stock market fund that invests in the entire U.S. stock market, an international equity fund, and a total bond market fund.
How Many Bonds Should You Own?
A total bond market fund provides broad exposure to government and corporate bonds with varying maturities. For example, Vanguard’s total bond market fund invests in over 10,000 U.S. government and corporate bonds.
Determining the right bond allocation depends on your age, when you wish to retire, and your risk tolerance. If you are risk-averse or close to retirement, your bond allocation should be higher than it would be for younger, more aggressive investors.
It’s important to note that financial professionals have traditionally recommended subtracting your age from 100 to get an appropriate bond allocation. For instance, if you are 40 years old according to this guideline, you should have 60% in stocks and 40% in bonds. However, with increasing life expectancy, many now recommend subtracting your age from 120.
What to Consider When Determining Portfolio Diversification
It’s important to take the big picture into account when determining the appropriate amount of diversification. Your goal is to reduce financial risk in case any individual investment fails, while still achieving sufficient returns.
Enhances
Stocks grow your portfolio, while bonds provide stability. The precise mix depends on your time horizon and risk tolerance. You can achieve instant diversification through mutual funds and then add individual investments that align with your goals. Alternative assets such as cryptocurrencies can add diversification to your portfolio and may allow you to achieve significant returns, but for conservative investors, the additional diversification may not be enough to justify the increased risk and volatility.
Frequently Asked Questions (FAQs)
How is diversification in a portfolio measured?
There isn’t a single measure. However, to achieve sufficient diversification, you want to have assets with little or no correlation, or those that have negative correlation, which means they move in opposite directions. Look at the correlation coefficient between any two assets, which ranges from +1 to -1. A negative number indicates they have a negative correlation. A number between +0.0 and -0.4 indicates low correlation.
How does diversification protect investors?
Diversification protects investors from the risk of any individual investment failing. Investing across different asset classes enhances this by protecting against the risks of a downturn in the stock market or problems in a particular sector, for example.
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Source: https://www.thebalancemoney.com/how-much-diversification-is-enough-357169
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