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With stocks and other assets booming for much of the past couple years, investors may find themselves with one or two securities that account for a large portion of their total portfolios. Now may be a good time to think about ways to diversify your portfolio so that your fortunes aren’t tied to just a few investments.
What is diversification?
Diversification is a way to manage risk in your portfolio by investing in a variety of asset classes and in different investments within asset classes.
Diversification is a key part of any investment plan and is ultimately an acknowledgement that the future is uncertain and no one knows exactly what’s going to happen. If you knew the future, there’d be no need to diversify your investments. But by diversifying your portfolio, you’ll be able to smooth out the inevitable peaks and valleys of investing, making it more likely that you’ll stick to your investment plan and you may even earn higher returns.
6 diversification strategies to consider
Here are some important tips to keep in mind to help you diversify your portfolio.
1. It’s not just stocks vs. bonds
When most people think about a diversified investment portfolio they likely imagine some combination of stocks and bonds. For decades, financial advisors have used the ratio of stocks to bonds in a portfolio to gauge diversification and manage risk. But that’s not the only way you should think about diversification.
Over time, portfolios can gain outsized exposure to certain asset classes or even specific sectors and industries within the economy. Investors who owned a diversified portfolio of technology stocks in the late 1990s weren’t actually diversified because the underlying businesses they owned were tied to the same trends and factors. The Nasdaq Composite index, which largely tracks tech stocks, fell nearly 80 percent from its peak in March 2000 to its low in the fall of 2002.
Be sure to think about the industries and sectors that you have exposure to in your portfolio. If one area carries an outsized weighting, consider trimming it back to maintain proper diversification across your portfolio.
2. Use index funds to boost your diversification
Index funds are a great way to build a diversified portfolio at a low cost. Purchasing ETFs or mutual funds that track broad indexes such as the S&P 500 allow you to buy into a portfolio for almost nothing. This approach is easier than trying to build a portfolio from scratch and monitoring which companies and industries you have exposure to.
If you’re interested in taking a more hands-on approach, index funds can also be used to add exposure to specific industries or sectors that you might be underweight. These funds can be more expensive than ones that track the most popular indexes, but if you’re interested in taking a slightly more active approach to managing your portfolio, they can be a quick way to add exposure to certain sectors.
3. Don’t forget about cash
Cash is an often overlooked part of building a portfolio, but it does come with certain benefits. Though it is a near certainty that cash will lose value over time due to inflation, it can provide protection in the event of a market selloff. Depending on the amount of cash in your portfolio and other investments you hold, cash could help your portfolio decline less than market averages during a downturn.
Cash also gives its holders optionality. This means that the value isn’t from holding the cash itself, but rather from the options cash gives you when the future environment is different from today’s. Most people tend to think of the investment opportunities available to them currently and ignore what might be available in the future. But when you hold some cash in your portfolio, you’ll be well-positioned to take advantage of any future investment bargains when the next market downturn comes.
4. Target-date funds can make it easier
Another way of maintaining a diversified portfolio is by investing in target-date mutual funds. These funds allow you to pick a date in the future as your investment goal, which is often retirement. When you’re far away from the goal, the fund invests in riskier assets like stocks and then shifts the portfolio’s allocation toward safer assets like bonds or cash as you get closer to your goal. You’ll want to understand how the fund is investing, but these can be great for people who are looking for more of a “set it and forget it” approach.
5. Periodic rebalancing helps you stay on track
Over time, the size of the holdings in your portfolio will change based on how the investment performs. Holdings with strong performance will become a greater percentage of your total portfolio, while the worst performers will see their weight decline. In order to maintain a diversified portfolio, it’s generally a good idea to rebalance the portfolio occasionally to the appropriate weight for each investment. You probably won’t need to do this more often than quarterly, but you should be checking on things at least twice a year.
6. Think global with your investments
With so many different investment options available in the U.S., it can be easy to forget about the rest of the world. But in a global economy, there are increasingly attractive opportunities outside a country’s borders. If your portfolio is entirely focused on the U.S., it might be worth looking into funds focused on emerging markets or Europe. As countries like China grow at faster long-term rates than the U.S., companies based there may benefit.
It can also be a way to better protect yourself from negative events that might impact the U.S. exclusively. Other markets may not suffer as much if the U.S. sees an economic slowdown. Of course, the reverse is also true. Emerging markets sometimes face challenges due to their underdeveloped economies and financial markets, which can cause bumps on their long-term growth trajectory. But diversifying your portfolio is about smoothing out the inevitable bumps no matter where they come from.
Can you be over-diversified?
While diversification is a key practice for most investment portfolios, the concept can be taken too far. Not all investments add diversification benefits to a portfolio, so it’s important to watch out for overlapping investments to avoid holding an over-diversified portfolio.
If you hold multiple funds in the same category, such as multiple small-cap stock funds or total stock market funds, you’re likely not getting much benefit from the additional funds. It’s like packing for a trip where you don’t know what the weather will be like and bringing four umbrellas – one umbrella is likely enough.
You’ll also want to watch out for funds of funds, which are funds made up of several other funds. These typically have high fees and are unlikely to add diversification to your portfolio. Focus on holding just one or two funds in each category and think about how different investments will interact with each other. You’ll get the most diversification benefit by holding uncorrelated assets, or assets that move in opposite directions of each other.
Diversification is ultimately about accepting an uncertain future and taking steps to protect yourself from that uncertainty. Reviewing your portfolio a few times each year can help keep your long-term plan on track and ensure you don’t have your goals tied to one or two investments.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past investment product performance is no guarantee of future price appreciation.