A diversified portfolio is a collection of investments in various assets that seeks to earn the highest plausible return while reducing likely risks.A typical diversified portfolio has a mixture ofstocks,fixed income, andcommodities. Diversification works because these assetsreact differently to the same economic event.
Key Takeaways
- You receive the highest return for the lowest risk with a diversified portfolio.
- For the most diversification, include a mixture ofstocks,fixed income, andcommodities.
- Diversification works because the assets don'tcorrelatewith each other.
- A diversified portfolio is your best defense against a financial crisis.
What Is a Diversified Portfolio?
In a diversified portfolio, the assets don'tcorrelatewith each other. When the value of one rises, the value of another may fall. The mixture can lower overall risk because, no matter what the economy does, some asset classes will benefit. That can offset losses in the other assets. Risk is also reduced because it's rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defense against a financial crisis.
How Diversification Works
Stocksdo well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.
Bondsand other fixed-income securities do well when the economy slows. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.
The prices of commodities varywith supply and demand. Commodities include wheat, oil, and gold. For example, wheat prices would rise if there is a drought that limits supply. Oil prices would fall if there is excess supply. As a result, commodities don't follow the phases of thebusiness cycleas closely as stocks and bonds do.
Include These Five Asset Classes to Diversify Your Portfolio
Here are six asset classes to help build a diversified portfolio:
U.S. Stocks
U.S. stocks are shares of U.S.-based public corporations. Companies of different sizes should be included. Company size is measured by itsmarket capitalization, so includesmall-cap,mid-cap, andlarge-capstocks in a portfolio. They respond differently depending on the phase of the business cycle.
U.S. Fixed Income
Fixed income investments pay an agreed-upon return on a fixed schedule. They include bonds, certificates of deposit, and money market funds.
Note
The safest investments are U.S.Treasurysandsavings bonds.
These are guaranteed by the federal government.Municipal bondsare also very safe. You can also buyshort-term bond fundsandmoney market fundsthat invest in these safe securities.
Corporate bondsprovide a higher return with greater risk. The highest returns and risk come withjunk bonds.
Foreign Stocks
These include companies from both developed andemerging markets.You can achieve greater diversification if you invest overseas. International investments can generate a higher return, because emerging-market countries are growing more rapidly. They are also riskier investments, because these countries have fewer central bank safeguards in place. They are susceptible to political changes and are less transparent.
Note
Foreign investmentshedgeagainst adeclining dollar.
U.S. companies do well when the dollar is weak because it boosts exports. Foreign companies do well when the dollar is strong. That makes their exports into the United States cheaper than when the dollar is weak.
Foreign Fixed Income
These include both corporate and government issues. They provide protection from a dollar decline. They are safer than foreign stocks.
Alternatives
Alternative investments can include a variety of assets and generally make up the smallest allocation, compared to the other asset classes. Examples of alternatives include real estate, commodities, hedge funds, venture capital, derivatives, or cryptocurrencies. Commodities can include natural resources such as gold or oil.
Goldis considered a solid part of a diversified portfolio because it's the besthedgeagainst astock market crash. Research shows that gold prices rise dramatically for 15 days after a crash. Gold can also be a good defense against inflation. It is also uncorrelated to assets such as stocks and bonds.
Note
Consider including the equity in your home in your diversification strategy.
Your Primary Home as an Asset
Most investment advisors don't count the equity in a home as a real estate investment. They assume you will continue to live there for the rest of your life.
That attitude encouraged many homeowners to borrow against the equity in their homes to buy consumer goods. When housing prices declined in 2006, many homeowners owed more than their property was worth. As a result, many people lost their homes during the financial crisis. Some walked away from their homes, while others declared bankruptcy.
Note
Many investment advisors consider your home to be a consumable product, like a car or a refrigerator, not an investment.
If your equity goes up, you can sell other real estate investments, such as real estate investment trusts (REITs), in your portfolio. You might also consider selling your home, taking some profits, and moving into a smaller house. That would prevent you from being house-rich but cash-poor. In other words, you won't have all your investment eggs in your home basket.
Diversification and Asset Allocation
How much should you own of each asset class? There is no universal best-diversified investment.
Investors useasset allocationto determine the exact mix of stocks, bonds, and commodities. Itdepends on your comfort with different risk levels, your goals, and where you are in life. For example, stocks are riskier than bonds. If you need the money in the next few years, you should hold more bonds than someone who could wait 10 years. So, the percentage of each type of asset class depends on your personal goals. They should be developed with a financial planner.
You should also rebalance according to thecurrent phase of the business cycle.In the early stage of a recovery,small businessesdo the best. They are the first to recognize opportunity and can react more quickly than big corporations. Large-cap stocks do well in the latter part of a recovery. They have more funds to out-market the smaller companies.
Note
Beware ofasset bubbles. They often occur when the price of any asset class rises rapidly.
Asset bubbles are bid up by speculators and are not supported by underlying real values. Regular rebalancing will protect you from asset bubbles. You should consider selling, or at least trimming, any asset that's grown so much that it takes up too much of your portfolio. If you follow this discipline, you won't get hit too hard when the bubble bursts.
Note
In a well-diversified portfolio, the most valuable assets are those that don't correlate with other assets.
When a Mutual Fund Is a Diversified Investment
A mutual fund or index fund provides more diversification than an individual security does. It tracks a bundle of stocks, bonds, or commodities. It is not a replacement for a well-diversified portfolio.
A mutual fund or index fund would be a diversified investment if it contained all six asset classes. To meet your needs, it would also have to balance those assets according to your goals. Then, it would adjust, depending on the stage of the business cycle.
Frequently Asked Questions (FAQs)
What is a portfolio?
In financial terms, a portfolio is a collection of investments. It might include stocks, ETFs, bonds, mutual funds, commodities, and cash and cash equivalents. It could also have assets like real estate and art. You might manage your portfolio, or you might hire a financial advisor to manage your portfolio on your behalf.
What is a mutual fund?
A mutual fund is a financial vehicle. It's made up of a pool of investors' funds used to invest in securities like stocks or bonds. They're operated by money managers and designed to meet certain investment objectives. They give investors some diversification because they typically hold a hundred or more securities.
Sure, let's break down the concepts in the article about diversified portfolios and the various asset classes used for building one:
Diversified Portfolio Overview:
A diversified portfolio is a collection of investments in various assets aiming to maximize returns while mitigating risks. Its core principle lies in the inclusion of various asset classes such as stocks, fixed income, commodities, and alternatives. The fundamental idea is to leverage the fact that these assets react differently to economic events, thus reducing overall portfolio risk.
Asset Classes in a Diversified Portfolio:
- Stocks: Represent shares of ownership in public corporations. They perform well during economic growth phases due to investors' optimism about future returns.
- Fixed Income: These investments provide agreed-upon returns on a fixed schedule and include bonds, certificates of deposit, and money market funds. Their performance shines during economic slowdowns as they offer stability and reduced risk.
- Commodities: This category encompasses goods like wheat, oil, and gold, whose prices fluctuate based on supply and demand. They don't closely follow the business cycle like stocks and bonds do.
Components of a Well-Diversified Portfolio:
- U.S. Stocks: Small-cap, mid-cap, and large-cap stocks to cover different phases of the business cycle.
- U.S. Fixed Income: Includes safe investments like U.S. Treasurys and savings bonds, alongside riskier options like corporate and junk bonds.
- Foreign Stocks: Companies from both developed and emerging markets to achieve greater diversification, albeit with higher risk.
- Foreign Fixed Income: Offers protection from a declining dollar and is safer than foreign stocks.
- Alternatives: Assets like real estate, commodities, hedge funds, venture capital, derivatives, or cryptocurrencies, which provide further diversification but typically constitute a smaller portion of the portfolio.
Additional Considerations:
- Primary Home as an Asset: Some consider the equity in a primary home as a consumable product rather than an investment. It's advisable to not overly rely on this asset for diversification.
- Diversification and Asset Allocation: The ideal mix of asset classes depends on individual risk tolerance, goals, and life stage. Regular rebalancing based on the business cycle and avoiding asset bubbles is crucial.
- Mutual Funds: Provide diversification by tracking multiple securities but shouldn't be considered a standalone diversified portfolio. A diversified investment fund would contain all major asset classes.
Common Questions Addressed:
- Portfolio Definition: A collection of various investments managed by an individual or a financial advisor.
- Mutual Fund: A pooled investment vehicle managed by professionals, offering diversification through a mix of securities aligned with specific investment objectives.
A well-structured, diversified portfolio is tailored to an individual's risk tolerance and goals, encompassing a range of asset classes that perform differently in varying economic conditions.
