Portfolio Diversification

Any beginner who wants to be successful in investing should understand diversification and learn how to build a diversified portfolio. Before embarking on an investment plan, you must understand the principles behind investing in various assets, which can be classified according to risk, asset class, geography, or sector. 

Investment guru Ray Dalio, the founder of Connecticut-based Bridgewater Associates, now an investment behemoth with $150 billion in assets under management (AUM), once said in an interview with Tony Robbins, “In general, it’s more important to know how to diversify well than it is to know how to pick the best assets.” 

Dalio believes in the benefits of spreading out investment risk. He also believes in picking uncorrelated assets to maximize return while dramatically reducing risk. “If you have uncorrelated assets, and you easily can because when the economic policies, when economic conditions shift, it shifts returns from one type of asset to another kind of asset," he explained.

Warren Buffet, one of the most renowned investors in modern history and chairperson of Berkshire Hathaway, is not entirely sold on diversification as an end-all, be-all principle. Still, he did go as far as to say, "Diversification is protection against ignorance." However, he continues, "It makes little sense if you know what you are doing."

Buffet argues that diversification is useless for successful investors who understand their investments in-depth.

As an investment concept, diversification is fundamental to anyone who wants to allocate money and resources to purchase a portfolio of assets that minimizes risk and improves opportunities in the long term. 

The Financial Industry Regulatory Authority (FINRA) says asset allocation is insufficient and defines diversification as "the spreading of your investments both among and within different asset classes." FINRA also emphasizes regular portfolio rebalancing, which means you must monitor your portfolio as the market changes.

Based on Dalio and FINRA's perspective, diversification can offer valuable lessons and protections to seasoned and inexperienced investors. However, as Buffet warns, it is not the only approach to investing and may even become less effective the more specialized you are. Furthermore, to simplify investing, you can use investment apps for beginners to understand the opportunities available.

Why diversify your portfolio?

Diversification is one of the significant cornerstones of investing. As a beginner, you may need to gain the skills to analyze the assets you invest in.

Moreover, without diversification, you end up with an over-concentration of investments, which may lead to substantial risk and losses. Here is a summary of the main reasons beginners should diversify their portfolios:

To mitigate risk

Beginners may need help assessing risk entirely or accurately. Even experts cannot fully determine the risks of investing in an asset. Diversification is a strategy to minimize risk by spreading investments across sectors and assets. It reduces the impact of the poor performance of any single investment.

Diverse assets perform differently at varying times. Performance is affected by market conditions, which we cannot always predict. Thus, they help minimize overall losses to the portfolio.

Portfolio diversification in itself is considered a risk management technique. It can be especially beneficial during periods of stock market and economic uncertainty.

To preserve capital

When you invest, one of the first things you need to do is assess your risk appetite. Conservative or risk-averse investors will aim first for capital preservation before they aim for growth. Capital preservation prioritizes preventing investment loss. 

Some retirement funds aim precisely at conservative goals, spreading their investments across less risky and more "reliable" investments with a history of minimized loss. Examples of such instruments are real estate instruments and annuities, a popular insurance product for guaranteed cash flow. 

You can factor in the preservation of capital into your diversification strategy. You typically consider several variables, such as age at the time of investment, level of responsibility, family income, closeness to retirement age, or annual income, for example. 

However, you must consult a financial adviser to understand this approach's pros and cons fully. 

To optimize returns 

Portfolio diversification allows investors to benefit from future growth. The diversity in asset classes is distributed across sectors. Hence, you can tap into sudden industry booms or regional growth over time. 

Not all sectors move alike. When done right, investors can tap into booms in specific sectors to boost overall performance. You can also benefit from compound interest generated by particular instruments, like mutual funds, in your investment mix. 

To optimize returns, you need to understand naive versus optimal diversification. Naive diversification is a diversification strategy where the investor selects securities at random to reduce risk due to the nature of the specified securities. 

By contrast, optimal diversification—Markowitz diversification—is more sophisticated and takes a different approach. With Markowitz diversification, you need to find assets whose correlation with one another is not perfectly positive. The more negative the correlation, the less they move together. 

This principle protects your portfolio in case one or more assets crash. The latter usually requires sophisticated computations involving computers running complex models and algorithms. The end goal is to find the ideal levels of correlation to reduce risk and maximize returns. 

To reduce portfolio monitoring and rebalancing efforts

For beginners, a diversified portfolio provides convenience and reduces the need for monitoring your portfolio. As beginners cannot do comprehensive portfolio and market analysis, diversification is a no-brainer strategy to get started.

Since some portfolio or asset review is required periodically as the markets shift, diversification reduces the need to look at your portfolio constantly. By contrast, a highly concentrated portfolio focusing on a high-risk asset class, say stocks, requires constant and frequent monitoring and may not be ideal for a beginner. 

portfolio Monitoring

How To Get Started on Portfolio Diversification

For beginners, diversifying assets can be daunting and take time and effort. However, you can follow some practical steps to get started on the process:

Determine your investment goals

Whether aiming for income generation, long-term growth, or preserving capital, you must define your investment goals early. What do you want from your investment in 10, 15, or 20 years? Do you want to preserve your capital, or do you want to make riskier investments in the hope of getting more significant returns? 

Having clear objectives will help you define your strategy. As always, you must consider your risk tolerance and time horizon.

Understand the various ways you can diversify

You can diversify via asset allocation, spreading investments across stocks, bonds, mutual funds, indexes, commodities, or real estate, among others. You can also diversify geographically. 

Geographical diversification means spreading investments across countries or regions to reduce regional or local risks. It also enables access to earning opportunities in various markets. For example, investing in developing economies can give you access to higher growth assets than in developed countries. 

It can also mean investing in a different region in the same state, city, or province. You can pick specialized or high-development zones within each region or country, such as Silicon Valley-like tech hubs sprouting in different parts of the world.

Another way you can diversify is through sector diversification. Sector-based diversification means that you invest in various sectors to avoid concentration risk. Fidelity recommends finding an investment theme. Sector diversification helps you gain exposure to industry trends that set you up for long-term growth.

Diversification Tips From the Pros

Here are some diversification strategies that make it easier for beginners to get started and understand specific approaches:

It’s more than just a stock-to-bond ratio

When diversifying, think beyond the "stocks vs. bonds" mentality. Gauge your risk by assessing your overexposure to specific industries. Avoid being overexposed to indexes with an outsized weighting or concentration in certain areas.

Use index funds to your advantage

Index funds can be used to diversify your portfolio at a lower cost. You can use them to add exposure to sectors you deem underweight in your overall portfolio.

The Ideal Starter Portfolio

A starter portfolio should cover several bases for a diversified portfolio. The right mix of lower-risk assets versus growth assets could set you up for a resilient financial future. 

For example, you could spread your investment across asset classes like equities (common and preferred stock, stock mutual funds, index funds, or ETFs), cash and cash equivalents, commodities, precious metals, and alternatives like real estate. 

You could also segment your exposure by sector or industry, such as defensive stocks, which are less affected by economic downturns, and tech stocks, which tend to rally during an overall bull market. Some financial experts would even invite you to consider other alternative assets, such as collectibles and structured products.

However, the proportion of each asset is determined by your investment size, risk appetite, and time horizon, among other factors. Are you diversified enough? You will be surprised to learn that individual assets within a single asset class are approximately 60 percent correlated, so keep refining your perspective. 

It is best to consult with a financial adviser or investment professional when making such decisions. 

Why invest in uncorrelated assets?

What are uncorrelated assets? An uncorrelated asset is one that isn't correlated with stocks. The asset's value does not move with the stock market. 

Expert investors believe uncorrelated assets are fundamental to any well-balanced and diversified portfolio. The rationale is that markets crash, as they always do, and uncorrelated assets will hold their value versus the stock market. 

T-bonds, or treasury bonds, are examples of a negatively-correlated asset to stocks. In a stock market crash, they typically don't lose their value. However, while offsetting your risks, the disadvantage of T-bonds is that they may lessen overall returns. 

Some believe that alternative assets are the holy grail of alternative assets—agricultural properties or farmland, real estate, and art are examples—because they can perform just as well as stocks and, at times, even better. 

Adding such assets to your portfolio may reduce your overall risk profile while assuring you will have some form of future return. The selection of which alternative to invest in can be a complex decision. 

Some believe you need at least 15 uncorrelated or 20 low-correlated return streams.

You can use diversification to manage the beta (risk measure). Afterward, you can overlay it with a robust set of investments for alpha (excess returns).

Beginners would benefit from the advice of a financial professional or adviser when embarking on alternative investments. 

Diversify Assets and Achieve the Holy Grail of Investing 

There is a reason diversification is called the “holy grail” of investment strategies. Diversification reduces volatility in a portfolio. A properly diversified portfolio will give its investor peace of mind. For a beginner, it may mean less risk and better chances of return. 

As a beginner, your overarching goal should be to reduce the need for risk analysis while taking advantage of the perks of diversification. While there are challenges to this strategy, you can start and stay focused by defining your goals early. What kind of returns do you want in the long run, and what risks are you prepared to take? You will need some help in reviewing and deciding on your portfolio. 

If you learn and master the fundamentals, you are on your way to the path of the greats, or at least towards keeping your investments safe and growing over time.