When many investors hear the term “diversification,” they assume it simply means spreading out their investments into different asset classes, such as having 70% of their investments in stocks and 30% in bonds.
While this is the most basic type of investment diversification, there are a number of ways to diversify that investors should consider. Below are some common questions — and answers — that explain why diversification is important, and how you can make sure your investment portfolio is varied in a manner that may help you in different economic conditions.
Q: A quick review: What is investment diversification?
A: At its most basic level, diversifying your investments means avoiding the mistake of putting all your financial eggs in one basket. Tracie McMillion, CFA®, Head of Global Asset Allocation for the Wells Fargo Investment Institute, explains that rather than putting all of your money in a very limited number of investments, you spread your money over a number of different stocks, bonds, cash, and other asset types.
Q: What kinds of investment types should I include in a diversified portfolio?
A: The primary classes over which you may want to consider allocating your investments include equities (stocks), real assets (such as real estate and commodities), fixed income (bonds, money market funds, etc.) and, if you’re a qualified investor, alternative investments (hedge funds private equity and private debt investments.
However, just allocating your investments over different asset classes isn’t quite enough.
Q: So what can I do to diversify my investments even more?
A: McMillion suggests considering additional layers of diversification. The major ones include:
- Geographic diversity: You can invest in both U.S.-based and international companies or funds. Your international component could be further separated into well-established (or developed) markets and lesser-developed countries (emerging markets).
- Company-size diversity: Companies are grouped into sizes as large-, mid- and small-cap stocks. Large-cap companies have a higher total market value (capitalization) (over $12.5 billion); mid-cap companies have moderate total market capitalizations; and small-cap companies have capitalizations on the lower end. A healthy investment mix would have a variety of large-, mid- and small-cap stocks or stock funds that have allocations to each type of stock.
- Sector diversity: Knowledgeable investors generally put their money into different “sectors.” A sector is a segment of the economy that includes companies providing the same type of products or services. These can include technology, health care, energy, finance, and so on. Diversifying your portfolio this way can help ensure that you don’t suffer significant financial losses if one industry is in trouble, since another market sector may do well at the same time.
- Investment-strategy diversity: Different investment managers may focus on different areas of the market. For instance, one manager might focus on value investing (buying undervalued stocks) while another manager might invest in companies with a strong record of earnings growth. Including managers with different investment styles, such as growth and value, in your portfolio can give you an added level of diversification.
Q: How can I tell whether my investments include these extra diversification layers?
A: If you own mutual funds, the fund prospectus discloses what assets are eligible for inclusion in the fund. Many mutual funds have names that suggest they focus their investments in particular investments, industries or countries: One fund might be called the XYZ Emerging Market Stock Fund, while another will be the XYZ Large-Cap Stock Fund. You can easily see what types of funds these are.
However, it can be very challenging to fully evaluate diversification levels on your own. Your Financial Advisor may be able to provide you with reports on the many types of diversification represented in your portfolio.
Q: If I’m investing in a mutual fund, isn’t it automatically diversified?
A: It could be, as many mutual funds invest in a wide range of different companies and even different asset classes, or in other mutual funds, such as target date funds. But while most mutual funds include a variety of investments, it doesn’t necessarily mean they’re well diversified. “You could invest in a fund that is made up of the same kinds of companies, perhaps a single sector of the U.S. market,” explains McMillion. “That’s not true diversification in that single fund.”
Q: Is it possible for my investments to be over-diversified?
A: It’s far more likely that you could add assets to your portfolio — in order to be “more diversified” — that really won’t make much difference to your risk or return expectations. “For instance, if you already hold a well-diversified bond fund, and you buy another three or four similar funds, you’re not changing your portfolio in any meaningful way,” explains McMillion.
Plus, you could be adding unnecessary complexity to your life, particularly if you’re buying similar funds on your own from several different fund companies, McMillion notes.
To learn more about diversification, talk to your Financial Advisor, who can show you the many different layers of diversification in your current portfolio and explain whether changes would make sense for your investment plan.