It pays to diversify. It’s become a truism about investing because the evidence demonstrates that it works. When you diversify holdings in your investment portfolio, you gain three key benefits:
- More opportunities. Owning a variety of investments gives you far more opportunities to earn strong returns because you are exposed to a wider range of markets.
- Risk management. If you spread out your holdings, you don’t have to worry about the declines in any one specific market having an outsized impact on your returns.
- A counter to the temptation of performance chasing. If you regularly follow the financial media, by reading The Wall Street Journal or watching CNBC, it can become a natural temptation to focus on the category of investments that currently seem hot. The problem with that strategy is that this year’s market leaders often aren’t next year’s. In fact, the category that is at the top of the performance charts one year often falls to the bottom of the charts the next. History suggests the average annual return you realize over time will be much higher if you pursue a diversified strategy rather than chase performance. It generally leads to a more a consistent, predictable level of return.
Once you commit to diversifying your investment portfolio, the next question is, “How do I do it?” The traditional formula for achieving diversification was a simple one. The earliest “balanced” funds simply offered at 60%/40% split between stocks and fixed income investments. The stock allocation was generally large-cap U.S. stocks, and the fixed-income portion was U.S. Treasury bonds. Today, there are far more opportunities to diversify your holdings.
Go deeper into each major asset class
U.S. large-cap stocks are not the only game in town. The equity markets offer many opportunities to mix things up.
- By company size. Large-cap companies are generally established firms. They’re less risky, but their growth rates may be more modest than those of small- and mid-cap companies. These companies are often in an earlier stage of their lifecycle, so their growth rates can be higher. For the same reason, though, they carry additional risk. The best strategy may be to own a mix of small-, mid-, and large-cap stocks.
- By region. The U.S. stock market has done very well since we emerged from the Global Financial Crisis of 2008-2009. But if you look at longer stretches of time, there have been periods when international stocks have fared better. Some international funds will provide you exposure to other developed markets, like the countries of Western Europe and Japan. Emerging market funds offer access to developing markets like China, Brazil, India and South Africa. These economies are in earlier stages of development, and for a variety of reasons, including their growing middle-class populations, the growth rates in these markets can be higher.
- By factor. In recent decades, much research has been done to identify factors – like company size, value, stock price momentum or the quality of a stock as determined by the company’s financial strength – that can drive stock returns over long stretches of times. Over shorter periods, current financial conditions can favor one of these factors over another. For long-term investors, it can pay to have a portfolio with diversified exposure to these various factors.
- By sector. Some funds will let you focus on certain sectors that might offer significant potential for long-term growth. Technology and biotechnology are the sectors that get all the attention these days, but there are a number of other sectors that also offer considerable opportunities. These can include consumer discretionary stocks or “old economy” companies in sectors like energy and industrials that may be benefitting from all the changes occurring as the world emerges from the pandemic-induced lockdown.
- By investment theme. Often, there are major long-term trends or political developments that can deliver significant returns for investors. For example, the global appetite for luxury goods continues to grow, providing substantial growth to companies that offer luxury cars, fashion, jewelry and a host of other high-end items. On the political front, the Biden Administration has proposed many incentives to promote Made in America, and these government initiatives, as well as a number of other factors, have rejuvenated American manufacturing companies. Investment strategies that focus on these trends and developments have the potential to provide investors with higher returns than the broad market can deliver.
Similarly, the bond market offers far more opportunities than U.S. Treasury bonds. There are multiple ways to diversify your fixed-income holdings.
- By return potential, credit quality and risk profile. With Treasury bonds, you generally don’t have to worry that your interest and principal payments will be at risk because the bonds are backed by the U.S. government. But that doesn’t mean Treasuries are risk free. The primary factor that drives Treasury returns is interest rates, and the price of Treasuries declines when rates rise. You can make your bond portfolio less dependent on interest rates by investing in corporate bonds as well. Corporates do have credit risk because companies could default on their interest or principal payments. These risks are lower with companies whose bonds are rated investment grade. You can also pursue even higher yields by investing in below investment-grade bonds, if you are willing to accept the extra credit risk. Again, the most effective strategy may be to diversify across the fixed-income spectrum.
- By tax treatment. Investors who are in high tax brackets might also want to consider municipal bonds because their income can be exempt from income taxes. Sometimes, the yield differentials between tax-advantaged and taxable bonds are so high that investors in almost any tax bracket could benefit from having these bonds in their portfolio.
- By region. International bonds offer the potential to earn higher yields, particularly in the emerging markets, where the interest payments on government- and corporate-issued bonds may be higher than those you find in the United States. One advantage of including investments outside the United States is your portfolio won’t be entirely dependent on what is happening with the U.S. economy.
Consider alternative asset classes
Stocks and bonds are traditional asset classes. But they tend to be influenced by the same factors – like the state of the economy and the level of interest rates – even if they respond quite differently to these same factors. Alternative asset classes – like commodities or real estate – offer you the opportunity to own assets whose value is often determined by a completely different set of factors.
Alternatives used to be an optional allocation for investors, and perhaps better suited only to affluent and sophisticated investors, who could manage the lack of liquidity and transparency that was often associated with these investments. Today, though, all investors have to contend with the slow rates of growth around the world, and the low levels of income available as short-term interest rates are close to zero or even negative in many countries. Allocations to alternatives have become essential for every investor to achieve the growth rates they need in their long-term portfolios.
The definition of alternatives also has to be broadened. Private equity, private credit and hedge funds have entered the mix. Now more investors may even want to consider digital assets, like bitcoin, or royalty financing, an investment structure through which funds are provided to new businesses in exchange for a fixed percentage, or royalty-rate, of the companies’ future revenues.
These alternative options, once available only to select investors, are becoming increasingly democratized and can provide investors with a range of attractive, uncorrelated investments for their portfolios.
Finding investments whose returns have low correlations is key
When you diversify, you want to own investments that won’t move in tandem. One way to evaluate whether investments move in lockstep or not is to look at their correlations. This is a measure of how closely different asset classes’ historical performance has tracked. Correlation is measured on a scale of -1 to 1. A correlation of 1 means the two asset classes move in the same direction and in total synch with each other. A correlation of -1 means they move in completely opposite directions but to the same degree. Using some examples from the correlations outlined in the chart below, you can see that the returns of large-cap growth stocks are not at all related to the performance of municipal bonds (a 0.01 correlation), while bonds would have moved in the opposite direction of whatever large-growth stocks are doing (a -0.22 correlation).
Find the mix that is right for your investment style and risk tolerance
Diversifying doesn’t mean you need to own everything. Knowing all the choices just helps you realize there is a large menu from which you can choose. You don’t have to order everything on the menu to build a solid portfolio. Pick the opportunities that interest you and that you know you’ll be comfortable with, but be sure you’re taking a balanced approach and selecting the investments that match your return goal, risk tolerance and personal preferences. That is the strategy that will likely deliver the best outcome for you.