11 Jan Why a Diversified Portfolio Is Crucial for Financial Independence
by Jay Bowen
At its most basic, diversification is an investing strategy used to manage risk. The underlying concept is to move money away from a single investment and instead invest across a wide range of different companies, industries, asset classes and even geographies. A diversified portfolio may include stocks, bonds, real estate and commodities from both the U.S. and across the world.
Spreading funds across opportunities avoids the risk inherent in only one investment type. For example, if 100% of a portfolio is invested in a single company, and if that company goes bankrupt, then all is lost.
While a seemingly easy concept to employ, diversification can be surprisingly difficult for many to consider for their own investment portfolios. This rings especially true for entrepreneurs and business owners. After all, they have spent years building up a business, including products or services in a particular industry or geography, which has led to financial success. Why should investing outside of their comfort zone make sense?
The Case for Portfolio Diversification
Simply put, all investors need diversification to minimize investment portfolio risk. Because we cannot predict the future, company performance fluctuates and markets are always changing, investors large and small diversify their portfolios among different companies, funds and asset classes to ensure that not all investments are exposed to the same risks at the same time.
While diversification is not designed to maximize returns, diversification can also be a way for entrepreneurs to get a feel for and benefit from investing in asset classes to which they may have been previously unexposed. For example, to take advantage of investing in the stocks of smaller companies or in the government bonds of emerging markets, investors can move a portion of their portfolio to these assets and with their wealth advisor determine if the risk outweighs the return.
Over time, a diversified portfolio generally outperforms the majority of more focused ones. This is because assets perform differently in similar markets. For example, when stock prices rise, bond yields fall. This negative correlation can benefit investors over the long term, and a diversified portfolio continuing with both asset classes minimizes risks while taking advantage of returns.
While not every investment in a well-diversified portfolio will be correlated, the goal of diversification is to buy and hold assets that do not move in lockstep with one another.
Can Over-Diversification Be a Problem?
Over-diversification can be as much of a problem as under-diversification. Investing in more and more different companies, industries, sectors, asset classes and geographies — just for the sake of diversifying — does not make sense if no additional returns are realized yet more risk is incurred.
Further, investing in more thinly traded asset classes, such as micro-cap stocks, may carry additional transaction fees, which cut into returns. Indeed, these hidden costs of seeking investments in diverse asset classes need to be considered carefully.
Concentration vs. Diversification
As mentioned earlier, many entrepreneurs believe in concentration in one domain because that is what has allowed them to build and grow their wealth over time.
Even those who have been employed in a particular company or industry for their entire careers may not fully appreciate the case for diversification. For example, an engineer who has held several positions at different companies in the oil & gas industry might not see the benefits of diversification beyond oil & gas, especially if his or her pension, 401(k) or direct ownership of stocks in oil & gas has soared over time.
However, concentration can have investors witness several periods of volatility. Their portfolios and savings will be left out from the returns or benefits of investing in a diverse range of companies, industries and asset classes.
As discussed above, diversification without limits can be as damaging as concentrating your wealth in one company or market sector. So how do you get a nicely balanced portfolio? These are a few of the most common strategies:
Many investors decide to take advantage of diversification by investing in mutual funds or exchange-traded funds (ETFs), which hold shares of hundreds or even thousands of companies. This is known as passive investing — the investor does not need to select the individual stocks, bonds or other assets in the fund — and can be a great way to diversify a portfolio that has not yet experienced the returns or risks of particular asset classes.
Is diversification the only way for investors to mitigate risk?
While investing in safer vehicles (i.e., shares of an S&P 500 index fund) can counteract the volatility of more risky investments (such as “junk bonds”), more sophisticated investors will go even further to minimize risk in their portfolios.
Hedging is a risk management strategy used to offset losses by taking an opposite position in a related asset. Using derivatives, such as options and futures contracts, investors can help protect themselves against downside risk. Hedging strategies also usually mean that potential profits are limited, since investors also need to pay for the options or futures contracts that they are using to hedge.
Collaring is an example of a hedging strategy in which an investor buys a put (buy) option and sells a call (sell) option for a particularly volatile stock in order to limit the losses. The profits are limited, and the net costs of the option transactions must also be figured into the profits. Hedging strategies can become quite sophisticated and are generally used in volatile markets and bear markets. A wealth advisor can help you determine whether hedging strategies are useful to you and your goals.
Investors may use an asset allocation model that assigns a percentage of a portfolio to different asset classes for defined periods of time as a strategy for capturing returns while minimizing risk. For example, younger investors have more time to build their portfolios and so may wish to assume more risk. As such, a larger portion of the portfolio may be allocated to stocks, even small-cap stocks, than to municipal or investment-grade bonds.
With an increasingly diverse portfolio comes an increasingly complex financial strategy. This is why choosing the right wealth advisor can be just as crucial as choosing the right way to to invest your hard-earned money. Investors should seek the advice of a trusted, experienced wealth manager to help them diversify their portfolios, select and allocate assets and manage risk.
For growing and maintaining financial assets, and for advice on how to transfer them wisely to the next generation, entrepreneurs can lean on the advisors at Gratus Capital.