One of the most common general rules when it comes to building a solid investment portfolio is diversification. But what exactly is diversification, and is it actually necessary?
Diversification is defined as “a risk management strategy that mixes a wide variety of investments within a portfolio.” The idea is over the long term, well rounded holdings will achieve more consistent returns with less risk. When combining non-correlated funds (or holdings that do not move in the same direction all of the time), even if one asset class falls, others may stay steady or rise. Essentially, it's following the thought process of not putting all of your eggs into one basket. Possible benefits include:
Obtaining more returns for the same amount of risk
Obtaining the same returns with less risk
Reducing fluctuations in a portfolio
Equally as important as identifying what diversification is though, is pointing out what it is not.
It’s Not Just Using One Index Fund
The S&P 500, which has about 500 holdings, does not really provide a whole lot of true diversification because it is made up of strictly U.S. Large Cap stocks. While it does include different sector exposures, it’s currently weighted heavily toward technology and sees a lot of the performance driven by the largest companies. In fact, the top 10 companies within the S&P 500 make up close to 30% of its total weight. Thus, it lacks in smaller companies, international, commodities, and more.
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It’s Not About Quantity
As demonstrated with the S&P 500, having more does not automatically equal diversification. For the most part, related stocks will rise and fall together, which means having 50 different bond funds won’t necessarily offer any protection if fixed income suffers either. Having a collection of similar holdings may actually be more detrimental, because there could be higher expense fees on some funds with a lot of repetition.
It’s Not About Different Institutions or Product Types
Having one account open with E-Trade and another Fidelity does not provide any risk protection from the markets. Regardless of where investments are held, they all still face the same market risk. Similarly, having different types of products does not necessarily lead to diversification either. It is very possible to have an ETF and a mutual fund that both largely serve the same purpose.
It’s Not One Size Fits All
There is no perfect allocation, otherwise everyone would use it. Ultimately, diversifying will look different for different individuals. It is important to consider goals, risk tolerance, and time horizon when determining how to build up a balanced portfolio.
There’s Still No Guarantees
Having a well diversified portfolio does not ensure that no money will ever be lost. Take a look at 2022 so far—there have been losses across the board without much relief. The one area that has held up better than others is commodities, which interestingly enough was one of the worst performing asset classes over the previous handful of years.
It can be difficult to stomach when certain holdings aren’t keeping up with others in the short-term, but diversification can help deliver a less volatile ride while helping achieve long-term portfolio goals for the patient investor.