Almost anyone who is learning about investing or has already started investing would’ve heard about the need and importance of diversification.
Unfortunately, many people, especially beginners, don’t really understand what it means.
And because they don’t understand what it means, when they think that they’ve successfully diversified their investments, that may not be and often is not the case at all.
In this post, I’ll go through a basic introduction about diversification and leave you with a simple 5-question framework that you can use to effectively diversify your investment portfolio.
What Is Diversification?
I think the biggest reason that people misunderstand diversification when it comes to investing is that they assume that it carries the same meaning of diversification outside of investing, in the general world.
That is, they think that diversification = variety.
While that may be true in the English language, the context of investing employs a more restrictive definition of diversification.
From Investopedia,
“A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk.”
And from Fidelity,
“Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited.”
Based on these definitions, diversification explicitly requires that one’s portfolio is not only spread out amongst a variety of investments but that they are of different types of assets.
While this most often refers to different asset classes, I don’t think that that always has to be the case.
Assets of the same asset class can be considered as different types of assets if fundamentally, they are sufficiently different.
This will result in varying extents of diversification on your portfolio.
Types Of Diversification
There are many different ways how investors can diversify their portfolio, so these are just some common examples and is not an exhaustive list.
Asset Class
As mentioned earlier, this is the traditional definition of diversification.
It allocates portions of the portfolio to different asset classes and is a common strategy used to manage risk.
For example, a fresh grad who is more risk-tolerant may have an asset allocation of 80/20 in stocks/bonds while a retiree who is more risk-averse may have an asset allocation of 20/80 in stocks/bonds.
Sector
Sector diversification allocates portions of the portfolio to different sectors of the market (ie energy, information technology, financials).
The rationale behind this is that different sectors tend to differ in performance and volatility, which can serve as a secondary measure to asset class diversification for managing risk.
This is usually done within an asset class, ie diversifying the sectors of one’s equity portfolio.
Market Cap
This refers to diversifying one’s equity portfolio among large-cap, mid-cap, and small-cap stocks.
In general, small-cap and mid-cap stocks are riskier than large-cap stocks but offer higher potential returns.
Since investors most commonly invest in large-cap stocks or equivalent ETFs (ie S&P 500 ETFs), market cap diversification presents a way for investors to increase their risk exposure in exchange for higher returns.
Country
Country diversification means allocating portions of one’s portfolio to investments in different countries.
This helps to reduce risk because some factors that affect a specific country may not have any or much impact on another country (ie China’s recent crackdown on their tech sector).
It also allows investors to be exposed to the potential returns of different economies.
How To Diversify Your Portfolio
Now, on to what you’re here for.
As I mentioned at the start of this post, many people who are new to investing don’t really understand what diversification means and as a result, fail to meaningfully diversify their investments.
With this 5-question framework, I’ll outline the thought process that should go into trying to diversify your investments and some of the things you should look out for.
1: Why Do You Want To Diversify?
This is the first and most important question you should ask yourself.
In order to devise an effective solution, you need to understand the issue at hand.
So before you can determine how you should diversify your portfolio, you need to know why you even want to diversify it in the first place.
Is it because you want to reduce risk?
To be exposed to different geographical markets/sectors?
Or is it because you read on some website that that’s what all investors should do?
Before you move on, you want to make sure that you have a clear and valid reason for diversifying your portfolio.
If you don’t, then maybe you don’t need to diversify your portfolio, and that’s completely fine.
2: Does It Make Sense?
After you’ve come up with why you want to diversify, the next thing you should ask yourself is whether or not it makes sense to do so.
That is, is this in line with your investment goals?
Will you be comfortable with making this decision?
Having a good reason to diversify your portfolio means nothing if it doesn’t make sense for you.
For example, say you have 100% of your investments in equity.
You’re thinking that it may be a good idea to diversify your portfolio to include some low-risk assets as a way to mitigate risk.
But if your investment goal is to accumulate long-term wealth over the next 20-30 years, and you are highly risk-tolerant, then even though this diversification would be a good move from an objective standpoint, it may make more sense for you to not diversify your portfolio.
Investing is something that is very personal – everyone has their own philosophies, goals, and risk tolerance. So something that may make sense for someone else won’t necessarily make sense for you.
Before proceeding, you want to make sure that diversifying your portfolio is something that makes sense for you.
If it doesn’t, then maybe now isn’t the time where you need to diversify your portfolio just yet.
3: What Do You Want Your Portfolio To Look Like?
Next, you need to have an idea of what your portfolio should look like.
This should be in such a way that it fulfils the reason you had for diversifying your portfolio in the first place.
For example, if your reason for diversification was to reduce risk, then your portfolio should end up with an allocation that reflects this – either by holding a smaller position in high-risk assets, a larger position in low-risk assets, or both.
This can be done at a high level by categorising your investments and having an idea of how much of your portfolio you want each category to constitute.
Also, try to have this breakdown in quantifiable terms like percentages because it makes your target portfolio more concrete.
Building on the example above, if your original portfolio was 100% in equity, you may want your diversified portfolio to be 90% equity and 10% in lower-risk assets.
Having a concrete idea of what you want your portfolio to look like will make it clearer for you when it comes to deciding how you’re going to end up there.
4: What Investments Can Get You There?
Now that you know what you want your portfolio to look like, you need to find out how you’re going to get there.
That is, what investments or assets will help you achieve your motive for diversification?
This is another important point that I think many people who are new to investing fail to consider properly.
In an attempt to diversify their portfolio, they invest in seemingly different products – after all, if they’re different, it’s diversified, right?
Going back to the definition of diversification in terms of investing, this is not true.
I’ve seen many people who considered investing in VOO and VT thinking that it will diversify their portfolio. The former is an S&P 500 ETF and the latter, a total world stock ETF.
While there’s no doubt that they are different ETFs, the issue lies in the fact that they’re not very different – almost all of the holdings in VOO are also held by and constitute a significant proportion of VT.
I’ve seen similar considerations for investing in VOO and QQQ (US tech ETF), and again, the same issue applies – QQQ is almost like a big subset of VOO, so there’s no real diversification to be gained.
So the key is that whatever you’re considering to diversify into must be sufficiently different from whatever investments you already have such that you will be able to gain some value that meets your need for diversification.
Asset Correlations
One metric that can help you decipher whether or not 2 or more investments are sufficiently different for the purpose of diversification is to check their correlation.
Correlation is a measure of the relationship or interdependence of 2 or more variables, ie investments, which ranges from -1 to 1 where 1 indicates a perfect correlation and -1 indicates a perfect negative correlation.
The more positively correlated 2 investments are, the more you’d expect their prices to move in similar patterns.
Conversely, the more negatively correlated 2 investments are, the more you’d expect their prices to move in opposite directions.
This is especially helpful if you’re diversifying your portfolio in order to mitigate risk, since having negatively correlated investments will help you tide through different economic conditions.
There are websites where you can check the asset correlations of various investments such as Portfolio Visualizer and Unicorn Bay.
The good thing about Portfolio Visualizer is that it allows you to check the correlation of multiple investments at the same time, but it only contains data on US-listed securities.
Meanwhile, Unicorn Bay contains data on a wide range of exchanges around the world, including cryptocurrencies, but only allows you to compare 2 assets at a time.
To prove my point about VOO, VT, and QQQ being not so different from each other, take a look at the correlation between them.
There is almost a perfect correlation between VOO and VT and an extremely strong correlation between VOO and QQQ.
Note that correlation alone is not sufficient to conclude how similar or different 2 investments are, but rather only serves as an indicator.
VOO and VBR are also strongly correlated, but this high correlation only tells us that they behave in similar ways, which is an indication that they may be similar investments.
Digging deeper into the holdings of each ETF, you’ll quickly realise that they are quite different in that the former consists of large-cap stocks while the latter, small-cap stocks.
5: Does It Still Make Sense?
Finally, ask yourself one last time if it still makes sense to diversify your investments.
Previously, you only did so at a high level by considering whether or not diversifying your investments was aligned with your investment goals and risk tolerance.
Now that you have more details as to how exactly you’re planning to diversify your portfolio, there may be more things you need to consider.
This could be a drilled-down version of the considerations you had previously, extending them to each individual investment you intend to make.
It could also include more detailed considerations like the costs you’ll incur as a result of diversification, which may be attributed to broker fees or ETF expense ratios.
To summarise,
There is only value to be gained from diversification if you do so with investments that are of different asset types.
This can include investments that are of different asset classes, market sectors, market cap, or from different countries.
5 questions that you can ask yourself in order to properly diversify your portfolio are:
- Why do you want to diversify?
- Does it make sense?
- What do you want your portfolio to look like?
- What investments can get you there?
- Does it still make sense?
Ultimately, you want to make sure that you will gain some value by diversifying your investments – and I believe these 5 questions can help in achieving this.
Hopefully, this post has helped you gain a better understanding of what it means to diversify your investments and how to do so effectively.
How are your investments diversified? Let me know in the comments below!