Investment diversification: how it works and why it’s important

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By Jamie Viceconte, Head of Investment Product | Citizens Wealth Management

Jamie joined Citizens Wealth Management in 2022 and is responsible for the curation and management of the investment product suite of ETFs and mutual funds, and portfolio models constructed with these products. As a strategic partner, he has over 30 years of experience in financial markets focused on a broad array of public and private equity and fixed income products.

Key takeaways

  • A diversified portfolio can mitigate market volatility, leading to more stable returns over time.
  • The assets in your portfolio can be reallocated for market movements or as your tolerance for risk changes while still helping you reach your financial goals.
  • Regular portfolio rebalancing helps you maintain proper asset allocation while maintaining your tolerance for risk.

"Don't put all your eggs in one basket."

It's a common expression and valuable advice when investing.

Diversification is a strategy intended to help ensure that you are not overly concentrated in a limited number of asset classes. It can help to reduce portfolio volatility while capturing market returns over time across asset classes. Lower volatility means relatively smaller moves up and down in a portfolio’s value over time.

What is diversification in investing?

Putting a large proportion of your net worth into one stock or asset class is a risky endeavor. If the value of that one stock or asset class drops significantly, it will dramatically reduce the value of your portfolio.

Diversification in investing is a strategy to reduce portfolio risk and volatility by allocating your investments across various asset classes. Asset classes are defined broadly as equity, debt, or cash. You can also define asset classes by company size and geography. Real assets like commodities or real estate, or other uncorrelated asset classes are often referred to as alternative asset classes.

The goal is to ensure that you are not overly concentrated in any one asset class in order to smooth out the inevitable dips and bumps that result from market volatility, while not giving up return over full market cycles.

For example, an investor could have a mix of large cap equities, bonds, international stock funds, and cash reserves. If one of those asset categories experiences a downturn, the other assets can help to mitigate the negative impact to overall portfolio performance.

While it doesn’t eliminate risk or ensure profitable returns, diversification can help to create the right balance of risk and return so that it aligns with your tolerance for risk and your investment goals. It may also help you feel more comfortable with the up and down movements of markets and your portfolio and give you confidence to stay with your long-term investment plan.

Pie Chart, What is Investment Diversification: Diversification is a strategy that aims to reduce portfolio risk and volatility by spreading your investments across a variety of asset classes and investments. This includes Cash, Stocks and Bonds.

Diversification among and within asset classes

For added protection against market fluctuations, many investors prefer to diversify their holdings within asset classes.

For example, instead of only investing in an S&P 500 index fund, an investor could diversify by spreading their investments across other index funds that track other equity market sectors, such as the Russell 2000 or the Dow Jones Industrial Average. International stocks or index funds are also an option to invest across various geographies and currencies.

You should diversify your holdings with fixed income asset classes to help balance your risk. Different types of bonds — like government, municipal, and corporate bonds — have varying degrees of risk. Risk can also be managed by investing in bonds with different maturity dates. Professionally managed bond funds are the most efficient way to obtain diversification across bond types and maturities.

Because they are highly liquid, investors can also diversify by holding a variety of cash equivalents. A cash equivalent is a type of short-term investment that can be quickly converted into cash, like T-bills, money market accounts, commercial paper, banker's acceptances, and CDs with very short maturities.

Making changes, reallocating, and rebalancing

Reallocating your portfolio can help optimize its performance. Assets can be bought and sold if market conditions change. You may also want to consider reallocating if your risk tolerance changes as you near retirement or if your goals change due to a major life event — like a new job, marriage, divorce, or the birth of a child.

There are a number of thoughtful ways to reallocate your investment portfolio to take advantage of market trends and volatility, such as:

  • Reduce assets in sectors that have outperformed and add to assets that you already have exposure to in sectors that have underperformed the broader market.
  • Replace assets in sectors that have outperformed with assets in sectors that you do not already have exposure to that have underperformed the broader market.
  • Periodically rebalance your portfolio to ensure asset classes remain properly weighted based on your financial goals and time horizon.

Understanding the impact of correlation

In academic terms, diversification means investing in asset classes that are not perfectly correlated, meaning they have a correlation of less than one. When two assets have a correlation of less than one, it means that they have historically behaved differently under various market conditions.

For example, stocks tend to have low correlations to bonds. Generally, this means that as stocks have fallen during market corrections, bonds have fallen less or even risen in value, potentially mitigating losses.

The key to smart investing

Diversification is an important concept for investors to understand and a tool to help manage risk and volatility in your portfolio. Balancing risk and return based on your unique financial goals and risk tolerance, a properly diversified portfolio could be the key to help you stay the course with your investment goals, especially in a volatile market. However, keep in mind that asset allocation, diversification, and rebalancing do not ensure a profit or protect against loss in declining markets.

We know that you have a lot to consider when it comes to your investments and diversification, but you don't have to make these decisions alone. Contact a Citizens Wealth Advisor* today for the personalized guidance and advice you need to navigate your financial journey.

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