Investment diversification is the process of investing across various asset classes, industry sectors and geographic regions. Diversification is the investing version of the old adage: “do not put all of your eggs into one basket”.
Diversification is about the trade-off between risk management and achieving solid investment growth over time.
Diversification and asset allocation
Asset allocation and portfolio diversification have become almost synonymous. Different asset classes have different characteristics and often react to market and economic conditions in different ways.
In diversifying your portfolio, you will want to include some asset classes that have a relatively low correlation to each other. For example, large cap U.S. stocks and bonds only have 26% correlation to each other. This means that only 26% of the movement of each asset class is tied together; the other 74% is based on factors unique to each asset class.
The right asset allocation will vary from investor to investor. Factors to consider include your investing time horizon, your risk tolerance and your investment goals. Diversification can help mitigate losses when the markets are in a downturn, or in the case of bonds, when interest rates are rising.
Types of Asset Classes
At a high level, core asset classes include stocks, bonds and cash. Within these asset classes are sub asset classes for stocks and bonds. Some sub-asset classes for stocks include:
● Domestic stocks
● Non-U.S. stocks
● Emerging markets
With bonds, there are long-term, intermediate term and short-term bonds. There are corporates, municipal bonds and Treasuries among a number of others.
Stocks represent ownership in a company. Shareholders are hoping to share in the success of the company through gains in the stock price. Many stocks also pay dividends, which is a way that many company boards of directors look to share the company’s profits with shareholders.
Bonds are essentially a loan to the issuing company or governmental entity. Bondholders receive interest payments at regular intervals, typically semi-annually. Upon maturity, the bond holders receive the face value of the bond.
Diversification Strategies & Rebalancing Your Portfolio
Many investors establish a target asset allocation and look to maintain their target allocation to stocks, bonds and cash. The allocation will often include an allocation to sub-asset classes like small-cap stocks and intermediate term Treasuries, for example. Allocations to holdings in certain sectors like energy or technology can also help you diversify your portfolio.
It is important to monitor your portfolio’s asset allocation. We do not suggest frequent rebalancing, but we do suggest reviewing your allocation quarterly, semi-annually or at least annually. It is a good idea to set acceptable percentage ranges for each asset class. If the allocation is above or below that range, then it is time to rebalance by either adding to the asset class or selling holdings.
There are a number of strategies that can be used in the course of rebalancing including tax-loss harvesting in taxable accounts and using new contributions to add to asset classes that need additional funding.
Tools and Resources for Diversification
While individual stocks and bonds can be used in building a diversified portfolio, mutual funds and ETFs are also excellent building blocks. Index funds offer the added benefit of generally being true to their investment style, making asset allocation and rebalancing a bit easier.
For those who have both tax-advantaged retirement accounts like 401(k)s or IRAs, be sure to include these accounts in your overall diversification strategy. It can often be more tax-efficient to do some of the trades needed to bring the portfolio back into its target allocation range in a 401(k) or IRA account.
An experienced financial advisor can be your best source for advice on the right level of diversification for your investment strategy. They can help with asset allocation, rebalancing, sector allocation and surety selection. An advisor can help you integrate your asset allocation with your overall financial planning strategy.
Diversification is an important part of your investing strategy. A properly diversified portfolio can help ensure long-term growth while helping to mitigate downside risk.
It is important to review your portfolio’s asset allocation on a regular basis and to rebalance your portfolio as needed. This can help you stay on track towards your goals. We encourage you to reach out to your Wedbush financial advisor for help establishing the right diversification strategy for your portfolio and for help reviewing your diversification over time.
These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable — we cannot assure the accuracy or completeness of these materials. The information presented is not intended to constitute an investment recommendation for, or advice to, any specific person. The information presented here is not specific to any individual’s personal circumstances. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstances. The information in these materials may change at any time and without notice.