Risk and investing go hand-in-hand. Without risk, you can’t seek rewards – but too much risk can jeopardize your portfolio. One way investors can constrain their risk is with portfolio diversification. Diversification spreads your risk by mixing a variety of investments in your portfolio. Limiting your exposure to any single company, industry or asset reduces the chances of losing everything when the market sours.
Portfolio diversification involves spreading money among many investments to limit your exposure to any one security. A well-diversified portfolio can smooth over volatility by putting money into assets that respond differently to the same market conditions. (Non-correlated assets.)
For instance, say that a market shock causes stocks to soar while real estate drops. If you own both, your real estate values may decline – but rising stock prices could offset your losses.
Bear in mind that diversification doesn’t guarantee profits or loss prevention. The goal of portfolio diversity is to mitigate volatility and various investment risks. No portfolio will ever completely eliminate risk – but you might see fewer or smaller ups and downs.
Portfolio diversification aims to minimize your risk exposure as much as possible. Reducing various risks can prevent you from incurring unnecessary losses while boosting your returns as high as possible.
Generally, investing incurs two kinds of risk: systemic risks and unsystematic risks. Diversification attempts to tackle the unsystematic variety.
Unsystematic risks are specific to a particular asset or investment. A company might face business risks due to aggressive competition or regulatory risks stemming from socially or environmentally sensitive operations. Smaller, growing or mismanaged companies may face financial risks due to liquidity issues or their financial structure.
Many of these risks are diversifiable. (That is, you can reduce their impact on your portfolio by carefully spreading your dollars.) But unless you avoid investing entirely, there’s no way to completely eliminate all these risks.
By contrast, systematic risks (market risks) are inevitable. These are the risks that come with investing, period, such as the risk that:
No matter how you diversify your investments, systematic risks will always exist. Still, diversification can take the edge off by investing across assets, industries and borders.
Achieving portfolio diversity also isn’t a one-and-done deal. As your investments’ values shift due to appreciation or market volatility, your asset allocation will reflect those changes. And as you age into new stages of life, you may find that your priorities or risk tolerance readjust, too.
Over time, that means your portfolio may no longer balance risk and reward for your needs. As such, you’ll likely find yourself rebalancing your portfolio periodically to keep your asset allocation and diversification in check.
You can diversify your portfolio several ways, and investors often combine multiple tactics at once. The most broad-strokes strategy is to buy assets from different asset classes, like stocks and bonds. But within that bucket, you can further diversify between industries and sectors, company size and domestic vs. international assets.
In investing, the main asset classes include:
Investing across asset classes is perhaps the simplest method of portfolio diversification. Many investors rely on asset class diversification to ensure their assets are appropriately non-correlated for their needs. Each asset class boasts its own risk-reward mixture that can further – or hinder – your goals.
Since many investors focus on stocks and bonds, another key diversification method is to invest by stock or bond type.
For instance, if stocks comprise half your portfolio, you may split evenly between dividend-paying stocks and aggressive growth stocks. Or, you could divide funds between blue-chip stocks and startups.
If the other half of your portfolio is in bonds, you might diversify between issuers, such as corporate vs. federal bonds. Selecting by risk level is another option, as is choosing bonds that pay different yields, no yields or are indexed to inflation.
As with asset class diversification, diversifying under these umbrellas is a fairly common strategy. Divvying up funds among versions of the same asset means you can capture returns – and circumvent risks – when different “segments” under- or outperform.
The key is to divide your investments to fit your strategy. For instance, if you’re a risk-averse investor, you may buy only TIPS and blue-chip stocks. But if you want to seek higher rewards, you could add high-yield corporate bonds and growth stocks to the mix.
Another way to achieve portfolio diversification is spreading investments across sectors. One huge benefit of this strategy is its applicability to almost every asset class.
Stock investors can select from any publicly traded company that offers stocks; bond lovers can diversify among a range of government- and corporate-issued bonds. You can diversify real estate (housing vs. healthcare); commodities (gold vs. oil); ETFs (index or sector funds); and so on.
Intermingling assets across industry and sector lets you spread risks and capture rewards inherent to each one’s business cycle and structure.
For instance, you might rely heavily on the tech sector’s aggressive growth to boost profits. But to mitigate the industry’s renowned volatility, you could diversify with defensive manufacturing, retail or healthcare assets to improve stability and lower risk.
You can also invest by industry preferences, such as shunning “sin stocks” or environmentally damaging industries like tobacco or mining.
Market capitalization, or market cap, measures a company’s worth by totaling the value of their outstanding stocks. Diversifying by market cap, then, means buying small, medium and large-sized companies to enjoy the risks and reward each presents.
Generally, there are three basic market caps to choose from:
Generally, larger market caps are more stable during turbulent markets, but present less growth opportunities. Smaller market caps are nimbler and may see greater growth, but may capsize in rough waters.
A well-diversified portfolio often means taking advantage of the benefits each market cap offers to offset risks presented by the others.
As an example, you might put 25% of your portfolio into slow-growing, dividend-paying large-cap stocks. Simultaneously, you could invest 10% of your portfolio into fast-growing small-cap stocks to hopefully capture enormous long-term price appreciation.
The above metrics represent just a few of the ways that investors can achieve portfolio diversity. Other strategies may include diversifying according to:
Each method presents its own risk-reward trade-offs that you should consider before switching up your diversification strategy.
It’s important to remember that the goal of portfolio diversification is mitigating risk, not just chasing returns. While these strategies can reduce volatility and smooth your long-term performance, they do carry downsides.
One great example of why portfolio diversification matters occurred during the Covid-19 pandemic.
Say that you purchased one of every stock in the tech-heavy Nasdaq Composite on February 14, 2020, just before the market crashed.
Assuming you kept your head when the market bottomed, you would have enjoyed some massive gains during later 2020 and 2021. But then in 2022, the tech sector entered a bear market, wiping out many investors’ gains.
Ultimately, between February 14, 2020 and December 30, 2022, your portfolio would have grown just 7.6%.
Now, say that instead, you bought a share of every stock in the wide-ranging S&P Total Market Index (TMI).
Once again, you would have experienced some initial losses and substantial gains in 2020 and 2021. But in 2022, when the tech sector crashed, the relative outperformance in other sectors would have buoyed your returns.
By December 30, 2022, your investments would have bloomed 12.7%. That’s a substantial improvement over the high-flying tech sector’s gains in the same period.
Portfolio diversification puts “not gathering all your eggs into one basket” into practice. By spreading your dollars into different assets, you can reduce certain risks and – hopefully – maximize your rewards.
That’s not to say that it’s automatically easy. While many index funds and ETFs offer instant diversification, you still have to do your research. Plus, these funds may not automatically rebalance to fit your risk profile when the market takes a turn.
But Q.ai does. Our in-house artificial intelligence (AI) analyzes current and historical patterns to find the best investments for our unique Investment Kits. Each Kit targets a specific goal, from building a solid investment foundation to looking to the future, allowing you to diversify immediately.
But it doesn’t stop there. Our AI also manages and mitigates risk within and between each Kit to optimize your long-term returns for your needs. Enjoy maximum control over your risk-reward allocation and diversification – all without piling extra research onto your own plate.
Q.ai is the trade name of Quantalytics Holdings, LLC. Q.ai, LLC is a wholly-owned subsidiary of Quantalytics Holdings, LLC ("Quantalytics"). Quantalytics offers automated financial advice tools through Quantalytics Investment Advisors, LLC ("QAI"), an SEC-registered investment advisor. QIA’s investment advisory services are ONLY available only to residents of the United States. Disclosures concerning QIA’s investment advisory services are available on its Form ADV filed with the SEC. The content in this newsletter is for informational purposes only and does not constitute a comprehensive description of Q.ai's investment advisory services.