How to diversify your portfolio

Financial markets are usually a reflection of the underlying real-world economy. The economic reality is however constantly changing and is evident in the market price volatility. The movement in market prices causes unwanted or unpleasant portfolio swings. To some investors these short-term price fluctuations continue to cause unnecessary stress or bring out an instinct to terminate investment portfolio altogether.

Diversification, however, helps investors to navigate market downturns and keep on building their wealth. The market volatility of 2022 has demonstrated once again that diversification is an important part of portfolio management strategy and can reduce the overall risks. Regardless of the recent turmoil in markets, patient and intelligent investors know that holding diversified asset portfolios or even adding to their investments during a period of market upheaval, will turn out to be a profitable strategy.

To put it simply, diversification is a strategy of not holding all your eggs in one basket. Building a portfolio from a mix of stocks from different sectors or industries and other investments (such as thematic ETFs, bonds, or real estate) will help minimize market price impact on the overall returns as well as providing a better risk-adjusted returns.

Key Diversification Rules

According to Fidelity investments, diversification is a strategy of splitting the capital into smaller investments so that the overall exposure to any single asset is limited. This in turn will limit the negative impact of market price movements. Such a strategy helps to reduce the volatility of portfolio returns.

When building a diversified portfolio, it is important to construct it from different asset classes such as stocks, bonds, real estate, and commodities in order to have uncorrelated returns.

Another important aspect of diversification is to stay diversified within each asset class. For example, the concentration of a single investment should not be bigger than 3-5%. Moreover, the portfolio should consist of several different sectors or industries along with geographical diversification.

Diversification & Asset Classes

Diversification is often seen as portfolio allocation or splitting capital into different asset classes such as equities, bonds, commodities etc. Some market participants, however, argue that the principle of diversification can also be applied to a single asset class.

Let us assess this theory by using 4 asset classes: stocks, 10-year treasuries, gold and REITs (Real Estate Investment Trusts).

In the example above, investing in a diversified multi-asset class portfolio helps to reduce volatility and, in some cases, achieve a better risk-adjusted return as compared to investing in a single asset class portfolio.

Diversification In Practice

What does diversification look like in practice? There are a few steps that can help make this process manageable:

1. Setting up goals and plans. Firstly, it is important to determine the investment horizon or more simply, whether the portfolio will be held up for one year, three or more than five years. For short-term portfolios, investors should aim to have the least volatile instruments, usually consisting of fixed income like bonds or bond ETFs. Mid-term portfolios would have more asset classes like stocks, and precious metals. And long-term portfolios can absorb more risk, therefore more risky assets can take a bigger part in allocation. Equally important are the financial goals. An investor should be able to answer the question whether the capital needs to be preserved, grown or alternatively kept liquid.

2. Level of Risk. The risk appetite of the investor will determine how volatile the portfolio returns can be and how many asset classes it will consist of. If the investor is risk averse, he/she should seek to have more asset classes and more instruments within the portfolio and such an investor would probably find ETFs as a tool to achieve broad diversification within the individual asset classes and between them. A more risk- tolerant investor would aim to build a more concentrated portfolio that has fewer asset classes and is less diversified in instruments (up to 20-30). Such investors would prefer to pick instruments like stocks themselves or would want to use thematic and smart beta ETFs.

3. Monitoring and Rebalancing. Once a portfolio is constructed, the values of assets that are in the portfolio will change over time. This means that the initial portfolio structure will change once as some of the assets will grow in value and others decrease. Therefore, monitoring asset price changes and performing portfolio rebalancing is crucial to maintaining portfolio structure as initially planned.

By rebalancing, an investor sells the assets that have appreciated in value the most and buys those that have lost value in this way maintaining the original balance of assets in the portfolio.

Rebalancing is usually done annually or semi-annually. Again, it is highly individual and can be done at one’s own discretion. To keep up to date with asset value changes, investors must monitor their investments semi regularly.

Effective Ways to Diversify Investment Portfolio

To build a well-diversified portfolio from single stocks and bonds investors must have enough capital in order to secure a healthy asset balance from all constituents. However, not all investors have enough funds to do so,  which leads us to the solution of ETFs.

ETFs are one of the fastest-growing investment products that enable retail investors to access highly diversified index portfolios in a cost-efficient way. ETFs can offer general indexes, sectors, themes, alternative asset classes and income strategies.

A single ETF unit gives a share of a well-diversified asset portfolio and through owning several different ETFs, a vast diversification is achieved.

Some ETFs are denominated in single or double digits which means that small investors can enjoy all the benefits of a well-diversified portfolio. ETFs allow investing both globally and locally into low-risk and high-risk assets and alternatives.

Conclusion

Diversification can help reduce asset price movements (namely volatility) because different asset classes or investments do not always move in the same direction over time. When one investment performs poorly, another part of the portfolio can perform positively, therefore, asset weights need to be balanced in order to get the best risk-adjusted returns.