Investment Diversification

Why Investment Diversification is Important

Diversification is an investment strategy that involves allocating funds across different kinds of investments to balance risk and reward and build a portfolio that is more likely to withstand market changes.

By spreading assets across various classes and sectors, you are not “putting all of your eggs in one basket.” A diverse portfolio mixes investments across classes and sectors, potentially reducing the impact of underperforming assets by offsetting them with others likely to perform well.

By reducing exposure to market volatility, your investment portfolio may be better equipped to deliver results and propel you closer to your financial goals.

Example of Portfolio Diversification

Focusing too heavily on a single asset class could slow the growth of your portfolio. Imagine an investor holds a portfolio consisting solely of technology stocks. If the tech sector experiences a downturn, their entire portfolio could suffer.

Now, imagine the same investor had diversified by adding bonds, real estate, and stocks from other sectors like utilities and healthcare to their portfolio. Poor performance due to a tech downturn wouldn’t be as harmful because it is offset by better performance elsewhere.

While diversification cannot guarantee profits or total protection against losses, it can improve the ability to withstand dips in individual asset classes or sectors.

Investment Portfolio Diversification By Asset Class

EP Wealth portfolio managers diversify investments in a few ways. First, they select investments from different classes to spread risk across categories. Let’s look at the most common asset classes and their role in portfolio diversification.

Stocks

A stock represents a share in a company’s ownership and a claim on its assets and earnings. Stocks generally have a good potential for growth and higher returns than other investments. However, investments with higher expected returns tend to be riskier, so balancing stocks with other products is typically a good idea to mitigate that risk.

Bonds

A bond is a loan to a company or government organization that pays interest to its investors. Investors make money from these payments and from the proceeds of selling a bond for more than they paid for it. Bonds are generally less risky than stocks. Yet the actual risk depends on the issuer’s creditworthiness and the likelihood that they can and will repay the debt.

Commodities

Commodities are raw materials like energy, metals, and agricultural products used to produce consumer goods. They can be bought and sold, and their price is based on their market. Commodities tend to rise with inflation, which can offset the adverse effects of inflation on other asset classes. Also, certain soft commodities like gold and oil can experience significant price increases, resulting in large returns.

Real Estate

Real estate is another good option for diversification. These assets generally appreciate over time, providing capital gains for investors. Also, because real estate prices are primarily determined locally, these assets can be used to balance underperforming stocks and bonds that are more susceptible to market fluctuations.

Cash

Cash and cash equivalents are not particularly high risk or high return. Still, cash reserves can be a helpful buffer during times of economic stress and can be used to invest when opportunities present themselves.

Sector Diversification

The U.S. economy is divided into various sectors, each comprising businesses that share similar products or services. Investing across all economic sectors aligns your portfolio with the U.S. economy and may potentially help protect it during events that substantially impact a particular stock or sector. One approach to sector diversification is to start with larger sectors like healthcare or technology.

From there, you can tap into other segments, balancing assets from smaller sectors that are more sensitive to the economy, like finance, with others that are less sensitive to market conditions, like consumer staples, which provide necessary goods and services.

Other Methods of Portfolio Diversification

Geographic Area

You can further diversify your portfolio by investing in assets based on a particular geographic area. If the U.S. and European stock markets experience a recession, you might allocate certain assets to emerging economies like China and India. Developing economies often have higher growth potential because they are less competitive than developed economies, where many businesses provide similar goods and services.

Company Size

Diversifying by company size, known as market capitalization, groups businesses by size and spreads risk across those categories. These categories range from micro-cap companies worth $50 million to $300 million to mega-cap companies worth $200 billion or more. The principle behind market capitalization is that the market favors different-sized companies at different times, so gains will offset losses as the market ebbs and flows.

Time Horizon

Time diversification is allocating assets according to a time horizon, with the premise that risk decreases over time. By mixing short-term, medium-term, and long-term investments, the goal is for assets with above-average returns to offset those with below-average returns in the long term. It may be recommended for events with a long time horizon, like saving for higher education or retirement.

Although you cannot control the economy, you can control the allocation of your assets. Diversification helps you stay the course and weather market changes as you move closer to your financial goals. EP Wealth portfolio managers tailor your investment strategy with the goal to help you achieve personal milestones and preserve and grow your wealth. Contact an advisor near you to learn more.