While there are several different investing strategies in constructing a portfolio, one makes sense for all investors: asset diversification. This applies to all styles of investing, such as value or growth.
Asset classes rise and fall over time, and being overallocated toward one type of investment may expose you to more risk than you need when volatility occurs, like the one caused by COVID-19. Portfolio diversification through thoughtful asset allocation is useful not only for risk management but also in helping you meet your various financial goals. Let's take a look at how you can build a diverse portfolio and reasons why you should.
What is portfolio diversification?
Portfolio diversification is the practice of allocating your investments across different asset classes. Common types include:
● Equities.
● Bonds.
● U.S. treasury bills.
● Currencies.
● Real estate.
● Mutual and index funds.
● Commodities.
However, there is no one-size-fits-all approach. The percentage you allocate toward different assets is dependent entirely on personal factors like your financial goals and risk tolerance. The main goals of diversification are to reduce risk, hedge investments and vary income streams from your investments.
Diversifying your portfolio comes with few drawbacks, and the advantages are significant.
Here are three specific reasons to consider portfolio diversification:
1. Easy to achieve
Because there is a range of subcategories within asset classes, you can diversify investments among many of them, and it is worth considering them all and how each might benefit your portfolio. The stocks you choose may be in companies with both large and small market capitalizations, as well as international stocks and exchange-traded funds. Some other asset classes are subdivided as follows:
● Bonds can be issued by local municipalities, federal governments and corporations, among other diverse sources.
● Commodities include precious and industrial metals and domestic and foreign currencies.
● Risk of loss to conventional asset classes can be hedged through derivative financial instruments such as options and futures contracts.
● Savings accounts like certificates of deposit (CDs) and interest-bearing accounts are valuable for stability of principal and income generation.
2. It provides better risk management
If your investments are concentrated in too few asset classes, you run the risk that volatility will take a disproportionate toll on your overall portfolio and amplify your losses. If, on the other hand, you spread your investments across different assets, you can better mitigate market-specific risk. If one class of assets trends downward, any loss to your portfolio may be cushioned by your other investments.
An important point to make is that portfolio diversification is not necessarily about avoiding losses entirely. It is more about ensuring you are not overexposed to any one risk, like a housing or stock market crash. Having investments that counterbalance one another can help limit your risk.
3. Helps meet short- and long-term goals
Allocating your investments in too few asset classes might make it more difficult to meet your financial goals, both short- and long-term. This might be especially true if a market decline reduces the value of a portfolio that has been set aside for home ownership, education or retirement savings. Because asset classes rise and fall over time, constructing a diverse portfolio can allow you to more effectively manage the short- and long-term investments that will help you progress toward your various goals.
To help meet those goals, it is always a good idea to revisit your portfolio allocation at least annually, which allows you to make adjustments as necessary. For instance, as you approach retirement, you may want your investments to become more conservative over time— which may mean tilting more toward investments that provide fixed income.
While portfolio diversification is an advantageous strategy, it can be time-consuming to research the right investments and optimize the right allocation for you. For that, you can work with your Comerica Wealth Advisor to help build a portfolio that reflects your personal risk tolerance and financial goals. Contact us today for more information.
