Reducing Risk with Diversification

Reducing Risk with Diversification

July 26, 2019

Diversification is a basic concept that's critical to building a portfolio able to withstand the test of time. It is the process of spreading your money among a variety of securities to reduce exposure to any one investment or asset class. The premise behind diversification is easy to grasp: When you diversify across a range of investments, you may reduce risk by creating the potential for better performers to compensate for poor ones.

Effective diversification involves more than owning different investments. It means selecting a mix of securities that may not react the same to a given set of conditions -- investments that carry a low correlation to one another. Correlation is a statistical measure of the degree to which two securities perform the same under market conditions. For instance, if you choose stocks of two companies that make the same product and serve the same market, chances are that they will move in tandem when conditions affecting their industry change. Owning both would be unlikely to lower risk in your portfolio. Alternatively, owning stocks of companies that operate in different segments of the economy may help improve your risk-adjusted return, although past performance is no guarantee of future results.

Diversifying by Industry

Combining stocks from different industries or sectors, for example Consumer Staples, Technology, Financials, and Materials may potentially result in a portfolio that has less risk than the individual industries or sectors. Of course, the portfolio may also have somewhat lower returns than some of the individual industries or sectors -- a trade-off that long-term investors may be willing to make.

Diversification vs. Asset Allocation

On its most basic level, diversification can be applied to asset classes by allocating your investments among the three fundamental asset classes: stocks, bonds, and cash. Your asset allocation is the percentage of money you decide to put into each asset class based on your goals, risk tolerance, and time horizon. Technically speaking, asset allocation may potentially reduce market risk; diversification potentially reduces company-specific risk. Together, they may help reduce portfolio volatility over time. Keep in mind that neither diversification nor asset allocation guarantees against investment losses.

Both asset allocation and diversification are particularly important when a market takes an unexpected downturn. Consider the investor who invested 100% in financial stocks at the beginning of 2008 as represented by the total returns of the S&P 500 Financials index. He or she would have lost approximately 55% of the portfolio by the end of the year. If the same investor had diversified his or her holdings to encompass a broad representation of all stocks by investing for example in an S&P 500 index fund, the losses would have been about 37% over this period. If the same investor had further diversified the portfolio by allocating 20% to cash and 30% to bonds and invested the remainder in the same S&P 500 index fund, losses could have been narrowed to about 16%.2

Putting Concepts to Work

How you diversify your portfolio among stocks, bonds, and cash will depend upon your specific goals, your time horizon, and your risk tolerance. A financial advisor can help you determine an allocation that suits your specific needs. You'll also want to revisit your asset allocation at least on an annual basis, making appropriate alterations depending on your goals.

With your allocations determined, you're ready to begin choosing investments for each asset class. Here, you have two basic options. The first is to research and assemble individual securities for your stock, bond, and cash allocations. This requires a significant amount of research and time to monitor and manage the individual securities.

Alternatively, you could diversify by selecting a mix of mutual funds or exchange-traded funds. Because they hold baskets of securities, such pooled funds provide instant diversification, although the degree of diversification varies depending upon each fund's investment strategy. A fund that replicates a broad market benchmark such as the S&P 500 would provide greater diversification than a fund specializing in one sector of the economy, such as utilities or health care.

Diversifying by Investment Type or Style

Within the different asset classes, you can also diversify your holdings by investment type or style. For stocks, there are several different styles to choose from: growth vs. value, large-cap vs. small-cap, domestic vs. foreign, or sector/industry. These and other style groups are all represented by numerous mutual funds that may react differently to market circumstances.

For bonds, there are many different types to select from. You may choose to diversify by type (government, agency, municipal, corporate), maturity, credit quality, or specific bond features, keeping in mind that different bonds react differently to market interest rates and other factors.

However, you choose to diversify your portfolio, remember that diversification works two ways. Although it can cushion the impact of a falling market, it can also dilute returns on the upside. Ultimately, you should balance your degree of diversification with your overall appetite for risk.


Core content sourced from DST Systems, Inc. DST Systems, Inc. For the period from January 1, 1990, through December 31, 2018. Sector performance based on the performance of the GICS sectors of the S&P 500 index. Real estate data begin from September 2006. It is not possible to invest directly in an index. Index performance does not reflect the effects of investing costs and taxes. Actual results would vary from benchmarks and would likely have been lower. Past performance is not a guarantee of future results. © 2019, DST Systems, Inc. All rights reserved. Not responsible for any errors or omissions. (CS000133)

2Source: DST Systems, Inc. Bonds are represented by the total returns of the Bloomberg Barclays U.S. Aggregate Bond index. Cash is represented by the Bloomberg Barclays U.S. Treasury Bill 1-3 Month index. Individuals cannot invest directly in an index. Past performance is no guarantee of future results.

Investing involves risks including possible loss of principal. No investment strategy or risk management technique can guarantee return or eliminate risk in all mark environments.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.