Diversification is often considered the only free lunch in investing. In one of my earlier blog posts, I talked about the practical benefits of diversification. I explained the concept of investing in uncorrelated asset classes and how it reduces the overall risk of the investments. In this article, I will walk you through 6 essential steps to diversify your portfolio.
1. Know your risk tolerance
Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional and spur of the moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.
Undoubtedly, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.
2. Understand your risk capacity
Often your willingness and actual capacity to take on risk can be in conflict with each other. You may want to take more risk than you can afford. And inversely, you could be away too conservative while you need to be a bit more aggressive.
Factors like the size of savings and investment assets, investment horizon, and financial goals will determine the individual risk capacity.
3. Set a target asset allocation
Achieving the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Typically, investors with higher risk tolerance will invest in assets with a higher risk-return profile.
These asset classes often include small-cap, deep value, and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors will lower risk tolerance will look for safer investments like government and corporate bonds, dividends and low volatility stocks.
In order to achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historical low dependence on each other’s returns.
The US Large Cap stocks and US Treasury Bonds are the classic examples of uncorrelated assets. Historically, they have a negative correlation of -0.21. Therefore, the pairs tend to move in opposite direction over time. US Treasuries are considered a safe haven during bear markets, while large cap stocks are the investors’ favorite during strong bull markets.
See the table below for correlation examples between various asset classes.
4. Reduce your concentrated positions
There is a high chance that you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account.
If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401k plan matching, stock awards, stock options, inheritance, gifts or just personal investing.
The risk of having a concentrated position is that it can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a substantial portion of your investments and retirement savings.
Managing concentrated positions can be complicated. Often, they have restrictions on insider trading. And other times, they sit on significant capital gains that can trigger large tax dues to IRS if sold.
5. Rebalance regularly
Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at a different rate, they will start to deviate from their original target allocation. This is very normal. Sometimes certain investments can have a long run until they become significantly overweight in your portfolio. Other times an asset class might have a bad year, lose a lot of its value and become underweight.
Adjusting to your target mix will ensure that your portfolio fits your risk tolerance, investment horizon, and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.
6. Focus on your long-term goals
When managing a client portfolio, I apply a balanced, disciplined, long-term approach that focuses on the client’s long-term financial goals.
Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy ignoring the fact that they may not fit with our financial goals and risk tolerance.
If you are about to retire, you probably don’t want to put all your investments in a new biotech company or tech startup. While these stocks offer great potential returns, they come with an extra level of volatility that your portfolio may not bear. And so regularly, taking a risk outside of your comfort zone is a recipe for disaster. Even if you are right the first time, there is no guarantee you will be right the second time.
Keeping your portfolio well diversified will let you endure through turbulent times and help your investments grow over time by reducing the overall risk of your investments.
About the author: Stoyan Panayotov, CFA is a fee-only financial advisor based in Walnut Creek, CA. His firm Babylon Wealth Management offers fiduciary investment management and financial planning services to individuals and families.