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

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.}

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

It's a common expression, but did you know it's also 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. This can help to reduce portfolio volatility while capturing market returns over time across asset classes. Lower volatility tends to mean relatively smaller moves up and down in a portfolio’s overall value.

We'll dive into what this exactly means and discuss some ways investors can diversify their assets.

What is diversification in investing?

Putting your entire 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. The more you have invested in the stock or asset class, the bigger the impact it can have.

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. We 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 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 investment goals. This may also help you feel more comfortable with the up and down movements of markets and your portfolio and give you confidence to stick with your long-term investment plan.

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, the Dow Jones Industrial Average, or the NASDAQ market. 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 bonds, municipal bonds, 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 provide diversification across bond type and maturity.

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 the broader market 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 the broader market 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 the value of stocks fall, the value of bonds has fallen less and even risen in certain markets. In the event of a stock market correction, your bonds may be able to provide balance to your portfolio and potentially mitigate 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.

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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