A diversified portfolio is a collection of investments in various assets that seeks to earn the highest plausible return while reducing likely risks. A typical diversified portfolio has a mixture of stocks, fixed income, and commodities. Diversification works because these assets react differently to the same economic event.
What Is a Diversified Portfolio?
In a diversified portfolio, the assets don't correlate with each other. When the value of one rises, the value of the other falls. It lowers overall risk because, no matter what the economy does, some asset classes will benefit. That offsets losses in the other assets. Risk is also reduced because it's rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defense against a financial crisis.
- You receive the highest return for the lowest risk with a diversified portfolio
- For the most diversification, include a mixture of stocks, fixed income, and commodities
- Diversification works because the assets don't correlate with each other
- A diversified portfolio is your best defense against a financial crisis
How Diversification Works
Stocks do well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.
Bonds and other fixed income securities do well when the economy slows. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.
The prices of commodities vary with supply and demand. Commodities include wheat, oil, and gold. For example, wheat prices would rise if there is a drought that limits supply. Oil prices would fall if there is additional supply. As a result, commodities don't follow the phases of the business cycle as closely as stocks and bonds.
Include These Five Asset Classes to Diversify Your Portfolio
Here are six asset classes to help build a diversified portfolio:
U.S. stocks are shares of U.S.-based public corporations. Different sized companies should be included. Company size is measured by its market capitalization. So, include small-cap, mid-cap, and large-cap in any portfolio. They respond differently depending on the phase of the business cycle.
U.S. Fixed Income
Fixed income investments pay an agreed-upon return on a fixed schedule. They include bonds, certificates of deposit, and money market funds.
The safest investments are U.S. Treasurys and savings bonds.
These are guaranteed by the federal government. Municipal bonds are also very safe. You can also buy short-term bond funds and money market funds that invest in these safe securities.
Corporate bonds provide a higher return with greater risk. The highest returns and risk come with junk bonds.
These include companies from both developed and emerging markets. You can achieve greater diversification if you invest overseas. International investments can generate a higher return because emerging markets countries are growing faster. They are also riskier investments because these countries have fewer central bank safeguards in place. They are susceptible to political changes and are less transparent.
Foreign investments hedge against a declining dollar.
U.S. companies do well when the dollar is weak because it boosts exports. Foreign companies do well when the dollar is strong. That makes their exports into the United States cheaper than when the dollar is weak.
Foreign Fixed Income
These include both corporate and government issues. They provide protection from a dollar decline. They are safer than foreign stocks.
Alternative investments can include a variety of assets and generally make up the smallest allocation compared to the other asset classes. Examples of alternatives include real estate, commodities, hedge funds, venture capital, derivatives, or cryptocurrencies. Commodities can include natural resources such as gold or oil.
Gold is considered a solid part of a diversified portfolio because it's the best hedge against a stock market crash. Research shows that gold prices rise dramatically for 15 days after a crash. Gold can be a good defense against inflation. It is also uncorrelated to assets such as stocks and bonds.
You should include the equity in your home in your diversification strategy.
Your Primary Home as an Asset
A type of commodity that some consider an asset class is the equity in your home. Most investment advisors don't count the equity in your home as a real estate investment. They assume you will continue to live there for the rest of your life.
That attitude encouraged many homeowners to borrow against the equity in their homes to buy other consumer goods. When housing prices declined in 2006, they owed more than the house was worth. As a result, many people lost their homes during the financial crisis. Some walked away from their homes while others declared bankruptcy.
Many investment advisors consider your home to be a consumable product, like a car or a refrigerator, not an investment.
If your equity goes up, you can sell other real estate investments, such as real estate investment trusts (REITs), in your portfolio. You might also consider selling your home, taking some profits, and moving into a smaller house. This will prevent you from being house-rich but cash-poor. In other words, you won't have all your investment eggs in your home basket.
Diversification and Asset Allocation
How much should you own of each asset class? There is no universal best-diversified investment.
Investors use asset allocation to determine the exact mix of stocks, bonds, and commodities. It depends on your comfort with different risk levels, your goals, and where you are in life. For example, stocks are riskier than bonds. If you need the money in the next few years, you should hold more bonds than someone who could wait 10 years. So, the percentage of each type of asset class depends on your personal goals. They should be developed with a financial planner.
You should also rebalance depending on the current phase of the business cycle. In the early stage of a recovery, small businesses do the best. They are the first to recognize opportunity and can react more quickly than big corporations. Large-cap stocks do well in the latter part of a recovery. They have more funds to out-market the smaller companies.
Beware of asset bubbles. That often occurs when the price of any asset class rises rapidly.
Asset bubbles are bid up by speculators. It is not supported by underlying real values. Regular rebalancing will protect you from asset bubbles. You should sell any asset that's grown so much it takes up too much of your portfolio. If you follow this discipline, you won't get hit too hard when the bubble bursts.
In a well-diversified portfolio, the most valuable assets are those that don't correlate with other assets.
When a Mutual Fund Is a Diversified Investment
A mutual fund or index fund provides more diversification than an individual security. They track a bundle of stocks, bonds, or commodities. A mutual fund is not a replacement for a well-diversified portfolio.
A mutual or index fund would be a diversified investment if it contained all six asset classes. To meet your needs, it would also have to balance those assets according to your goals. Then, it would adjust depending on the stage of the business cycle.