How to Diversify Your Portfolio
November 4, 2022
How to Diversify Your Portfolio
November 4, 2022
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Go to almost any store or website that sells something—anything—and you will find several other products for purchase. In fact, you would be hard-pressed to find any place that sells one thing and one thing only. There is a huge, perhaps business-saving reason for this: having a diversified product line can mitigate risk and protect profits. For example, if a certain product falls out of favor, is no longer profitable, or experiences an issue that makes it impossible or too expensive to produce, having other products means your business can likely stop producing/selling the item and still achieve a profit—and stay in business. Similarly, when investing, all your nest egg should not be in one figurative basket. To mitigate some of the risk, investments are often spread across different asset classes and securities.
According to Fidelity, “Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.” For example, if a particular sector that you’re invested in is struggling to move up or even declining, another sector in your portfolio might help offset the decline—Your risk tolerance, investment horizon, and investing experience and overall financial goals should be considered when evaluating how to diversify your portfolio. You can read more about diversification and why it matters to your financial future here.
This article explores various asset classes as they relate to diversification including stocks, index funds, bonds, annuities, money market funds, commodities, and real estate funds.
Diversification via Asset Classes
According to Fidelity, “Stocks represent the most aggressive portion of your portfolio and provide the opportunity for higher growth over the long term. However, this greater potential for growth carries a greater risk, particularly in the short term. Because stocks are generally more volatile than other types of assets, your investment in a stock could be worth less if and when you decide to sell it.”
Within the world of stocks, further diversification includes cyclical stocks and defensive stocks. Cyclical companies offer goods and services that are considered non-essential and follow the overall economy’s cycle—with ups and downs charting economic expansions and peaks, recessions, and recovery periods. Defensive stocks are generally blue-chip companies in sectors that provide essential goods and services. Defensive stock companies are less likely to be shuttered if the economy takes a downturn.
International stocks are another way to add diversification to a portfolio. According to Fidelity, “Stocks issued by non-US companies often perform differently than their US counterparts, providing exposure to opportunities not offered by US securities. If you’re searching for investments that offer both higher potential returns and higher risk, you may want to consider adding some foreign stocks to your portfolio.”
2. Index Funds
If you have index funds in your portfolio, you are already ahead of the game where portfolio diversification is concerned. An index fund, such as S&P 500 or Dow Jones Industrial Average, holds a bucket of varied stocks from different companies, so your risk is spread across many stocks instead of concentrated in one or two.
3. Target-Date Funds
Target date funds are another way to provide diversification in a portfolio. According to Investopedia, “Target-date funds are a variety of actively managed funds that are designed to ‘mature’ at a specific time. Target-date funds are managed so that the securities in the fund are allocated in an increasingly conservative allocation as the target date approaches.” Many 401(k)s are set up as target-date funds.
Bonds represent a loan from the buyer (you) to the issuer of the bond, governments, or corporations, when they want to raise money. By buying a bond, you give the issuer of the bond a loan, and they agree to pay you back the face value of the loan on a specific date, and to pay you periodic interest payments along the way, usually twice a year. Unlike stocks, bonds issued by companies give you no ownership rights. Therefore, you will not necessarily benefit from the company’s growth, but you won’t see as much impact when the company isn’t doing as well, either—as long as it still has the resources to stay current on its loans. Bond interest rates can often be lower than returns on other investment vehicles, such as stocks or index funds, so returns are generally more limited.
There are three main types of bonds: corporate, high-yield, and municipal bonds. Corporate bonds are issued by both public and private companies and have a high credit rating- referred to as investment-grade – which means they have less credit risk when compared to high-yield bonds. High-yield bonds have a lower credit rating, implying higher credit risk, than investment-grade bonds and, therefore, offer higher interest rates in return for the increased risk. Municipal bonds are issued by governmental entities, including cities, counties, and states. Municipal bonds are safer than high-yield bonds, as the issuing government entity can tax their citizens to pay bondholders.
An annuity is an agreement between you and an insurance company, also known as the insurer, that requires the insurer to pay you a regular income now or in the future based on the agreed-upon terms. The payment can be a lump sum or a series of payments over time. Annuities are backed by the claims-paying ability of the insurer, so selecting a reputable annuity issuer is important.
There are three types of annuities: fixed, variable, and indexed. A fixed annuity is where the insurance company gives you a fixed rate of return on your contributions for a specific number of years. A variable annuity allows you to direct your annuity payments to different investment vehicles, such as mutual funds. Your payout will depend on how much money you put in and the return of the investment funds. An indexed annuity usually will give a return that is correlated with an index such as the S&P 500 Index. Some annuity payouts have pre-specified caps, meaning your returns will not exceed the cap, no matter how well the market does above it. You can read more about annuities here.
6. Money Market Funds
According to Investopedia, “A money market fund is a kind of mutual fund that invests in highly liquid, near-term instruments. These instruments include cash, cash equivalent securities, and high-credit-rating, debt-based securities with a short-term maturity (such as U.S. Treasuries). Money market funds are intended to offer investors high liquidity with a very low level of risk.”
A money market fund usually consists of one of the following: Banker’s Acceptances (BA), certificate of deposits (CDs), commercial paper, repurchase agreements (Repo), and U.S. Treasuries. Banker’s Acceptances are a short-term debt vehicle that a commercial bank guarantees. A certificate of deposit, commonly known as a CD, is a savings vehicle that allows you to earn interest on a lump sum for a fixed period. Commercial paper is an unsecured short-term corporate debt investment. Repurchase agreements are short-term government securities. U.S. Treasuries are government debt issues. You do not have to invest in all the available money market funds but including some of the funds can help to diversify your investment portfolio.
According to US News, “A commodity is a raw material that is typically used as input for producing other goods or services.” Investors can buy and sell commodities directly or trade commodity derivatives on public exchanges.
There are four main classes of commodities:
- Energy (such as oil)
- Metals (such as gold and silver)
- Agricultural products
- Livestock and meat
Investing in commodities futures contracts or commodity ETFs are ways to gain exposure to commodities. It is important to note that commodities tend to be much more volatile than other asset classes and have their own unique sets of risks, including price risk, quantity risk, cost risk and political risk.
8. Real Estate Funds
Instead of investing directly in physical real estate, which can be illiquid, investing in real estate funds may be another way to diversify your portfolio. According to Investopedia, “A real estate fund is a type of mutual fund that primarily focuses on investing in securities offered by public real estate companies.”
There are typically three types of real estate funds: Real estate exchange-traded funds (ETFs), real estate mutual funds, and private real estate investment funds. Real estate exchange-traded funds are traded like stocks, while real estate mutual funds are also traded like stocks but can be open- or closed-ended. A limited number of shares will be available to the public if it is closed-ended; however, if it is open-ended, there will be an unlimited number of shares open to the public. Private real estate investment funds are usually only available to high-net-worth investors.
Do note that real estate funds typically do not pay dividends. You make a profit as the value of the fund increases, like mutual funds.. If you want to invest in a real estate product that may pay dividends, a real estate investment trust (REIT) is a vehicle to explore. Per Investopedia, a REIT can be a “corporation, trust, or association that invests directly in income-producing real estate and is traded like a stock.” REIT portfolios can include domestic housing, commercial real estate, and undeveloped land, like timber.
Both REITs and real estate funds are ways to add diversification to a portfolio. The decision to invest in REIT or real estate funds will depend on your time horizon, risk tolerance and specific investment goals.
9. Cash (or cash equivalents)
It bears mentioning strategically holding a percentage of cash is a key component to a diversified portfolio. According to NerdWallet, cash also “acts as ‘dry gunpowder’ to invest during opportune times.” This is a low-risk, low-reward asset class, also can provide a buffer during volatile times in the market. Finally, maintaining cash provides an emergency fund for unexpected events like job loss, a big home purchase/ repair, or medical bills.
The percentage of your portfolio that should be allocated to each asset class is determined primarily by your risk tolerance and time horizon for when you need the invested money. For example, if you will not need the money for 20 or 30 years, you can invest in stocks and asset classes that are more aggressive, since markets overall tend to trend upwards over time. Also, the longer the time horizon, the longer the power of compounding has to work. Generally, the longer the time horizon the more aggressive an investor can be and vice versa. Conversely, if you are a conservative investor or have a shorter time horizon, you may want to invest in asset classes that are not as volatile. Regularly evaluating the asset classes you are invested in and rebalancing as appropriate are important steps to take to ensure your investments are aligned with your needs and goals. This Fidelity article illustrates the impacts of building a diversified portfolio and rebalancing.
When investing, it is essential to ensure that your portfolio is diversified. Investing in only one asset class can leave you exposed to more risk, as it is almost impossible to predict which asset class will perform well in any given time period. You can better mitigate this risk through diversification among asset classes, including stocks, index funds, target-date funds, bonds, annuities, money market funds, commodities, real estate funds and cash.
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Cussen, Mark. (September 29, 2022). Target-Date vs Index Funds: Is One Better? Investopedia. https://www.investopedia.com/articles/financial-advisors/073015/targetdate-vs-index-funds-one-better.asp#:~:text=Target%2Ddate%20funds%20are%20a,objective%20without%20any%20portfolio%20turnover.
Fidelity.com. (n.d.). Why diversification matters. https://www.fidelity.com/learning-center/investment-products/mutual-funds/diversification#:~:text=Diversification%20is%20the%20practice%20of,of%20your%20portfolio%20over%20time.
Investor.gov. (n.d.). Annuities. https://www.investor.gov/introduction-investing/investing-basics/investment-products/insurance-products/annuities
Lam-Balfour, Tiffany, Royal, James, & Ayoola, Elizabeth. (Oct 7, 2022). Investment Diversification: What It Is and How To Do It. Nerdwallet. https://www.nerdwallet.com/article/investing/diversification
Segal, Troy. (April 7, 2022). Money Market Funds: What They Are, How They Work, Pros and Cons. Investopedia. https://www.investopedia.com/terms/m/money-marketfund.asp
Duggan, Wayne. (May 5, 2022). Commodity Definition. US News. https://money.usnews.com/investing/term/commodity
Hayes, Adam. (May 23, 2022). REIT vs. Real Estate Fund: What’s the Difference? Investopedia. https://www.investopedia.com/ask/answers/012015/what-difference-between-reit-and-real-estate-fund.asp