Diversifying Your Investment Portfolio
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When it comes to investing, the old adage "don't put all your eggs in one basket" rings true. Diversification across different asset classes is a key strategy for any investor looking to maximize returns while minimizing risk. By spreading your investments across asset classes like stocks, bonds, commodities, real estate and exchange-traded funds (ETFs), you create a balanced portfolio that can provide more stable growth over time.
In this post, we will examine the major asset classes, the benefits and risks of each, and how to allocate your investments wisely among them to create a diversified portfolio tailored to your individual financial goals and risk tolerance. Proper diversification allows you to reap the upsides of multiple asset classes while protecting against downswings in any single market. With the right mix of investments, you can aim for an optimal balance of risk versus reward.
Overview of Major Asset Classes
Stocks, also known as equities, represent ownership shares in public companies traded on stock exchanges like the NYSE and Nasdaq. When you purchase stock in a company, you become a partial owner. Stocks offer investors the potential for capital appreciation as the share prices increase in value over time. They also provide income in the form of dividends paid out regularly by many companies. However, stocks tend to be more volatile and risky in the short-term.
Bonds are essentially loans issued by governments, municipalities, and corporations looking to raise capital. When you buy a bond, you are lending money for a defined period of time and receiving interest payments in return. Bonds are generally less risky than stocks and provide more steady income, but limited capital appreciation potential.
Commodities refer to basic goods and raw materials, including agricultural products like corn, wheat and pork bellies; natural resources like oil, gold and natural gas; and industrial metals like copper and aluminum. Commodities can diversify a portfolio since their price movements often have low correlation to stocks and bonds. They also provide an inflation hedge. However, commodities tend to be highly volatile.
Real estate can be owned directly in the form of property or indirectly through vehicles like real estate investment trusts (REITs). Real estate provides diversification away from paper assets since its value is derived from physical property. It also offers potential for appreciation as property values increase over time. Real estate investment comes with expenses like maintenance, taxes and management fees.
Exchange-traded funds (ETFs) have surged in popularity in recent decades as an easy way to invest in a diversified basket of assets from stocks and bonds to commodities and real estate. ETFs provide low-cost access to entire index funds or market sectors. The diversified nature of ETFs helps reduce risk compared to owning just a few stocks. However, ETFs still carry risks related to the underlying assets.
Now that we've covered the major asset classes that retail investors like you and I have access to at a high level, let's examine each one in more detail along with the key benefits, risks and portfolio allocation recommendations.
Stocks, also referred to as equities, represent ownership shares in publicly traded companies. When you purchase shares of stock, you become a partial owner in that company and entitled to your share of its earnings and assets. Stocks are traded on public exchanges like the New York Stock Exchange and the Nasdaq.
Some of the key benefits of stocks as an asset class include:
- Growth potential - Stocks offer investors the opportunity for capital appreciation as company share prices increase in value over time along with the underlying company's growth. Investing early in companies with strong growth prospects can yield very strong returns.
- Dividend income - Many established companies provide regular dividend payments to shareholders out of company profits. These dividends provide a stream of investment income. Blue chip companies in particular are known for consistent dividend payouts.
- Liquidity - Stocks are highly liquid investments that can be readily converted to cash on short notice by selling on the public markets. This makes stocks more accessible than less liquid assets like real estate.
However, stocks also come with heightened risk, including:
- Volatility - Stock prices fluctuate constantly, sometimes significantly in the short-term, which can lead to big swings in the value of stock investments. Stocks are considered riskier investments as a result. Individual stock picking is generally higher risk compared to broad market index funds which is reflected in the higher volatility.
- Potential for loss - If a company performs poorly or goes bankrupt, its stock can decline and become worthless, leading to a total loss of investment capital. Individual poor-performing stocks can sink an otherwise strong portfolio.
Types of Stocks
There are a few major categories of stocks that investors typically choose from:
- Large-cap stocks - Shares of large established companies with market capitalizations above $10 billion, such as Apple, Microsoft and Google. Large-caps are lower risk than small companies.
- Mid-cap stocks - Companies with market capitalization between $2 billion to $10 billion are considered mid-caps. They offer moderate risk/return potential.
- Small-cap stocks - Shares of smaller emerging companies under $2 billion in market cap. Small-caps involve more risk but also growth potential.
- Growth stocks - Companies and sectors expected to grow earnings faster than average, such as technology and biotech. Growth stocks have high valuations and potential gains.
- Value stocks - Mature companies with stable assets trading below their intrinsic book value due to market underpricing. Value stocks involve less risk.
Stock Investment Strategies
Some approaches to investing in the stock market include:
- Active stock picking - Analyzing individual companies to select certain stocks to invest in based on their perceived growth prospects and value. This takes time and research.
- Index fund investing - Passively investing in a fund tracking a stock market index like the S&P 500. This provides diversified market exposure at low cost.
- Income investing - Focusing on stocks paying high dividends for investment income. These are often mature, stable utility and consumer staple companies.
- Sector investing - Investing in ETFs or funds focused on particular sectors expected to outperform, such as technology, healthcare or energy stocks. This concentrates risk.
Stocks tend to make up the largest allocation in many investor portfolios. A prudent starting point is dedicating 50-70% of your portfolio to stock investments, within your risk tolerance. More conservative investors might allocate 30% or less to stocks, while more aggressive investors might allocate 70-90% or more to stocks. Rebalancing periodically helps maintain your target asset allocation over time.
Bonds represent debt instruments issued by various government and corporate entities looking to raise capital from investors. When you purchase a bond, you are essentially loaning money to the bond issuer in exchange for a promised rate of return via regular interest payments and return of principal upon the bond's maturity.
Here are some of the advantages bonds offer as an asset class:
- Income - Bonds provide regular interest income to investors in the form of coupon payments made semiannually or annually until maturity. This creates a steady income stream.
- Stability - Bonds are considered less risky and volatile compared to stocks since they provide fixed, regular payments. This makes them suitable for conservative investors.
- Diversification - Bond prices often move independently from stocks, making them important portfolio diversifiers. Not being correlated helps smooth out volatility.
- Capital preservation - If held to maturity, most bonds return your full principal investment. This helps preserve capital during stock market declines.
However, bonds also come with some disadvantages to consider:
- Interest rate risk - Rising interest rates will cause existing bond prices to fall, since new bonds are issued at higher yields. This erodes bond investment value.
- Inflation risk - Persistent inflation can reduce the purchasing power of fixed bond interest payments and principal over time.
- Default risk - The chance that the bond issuer cannot repay the bond, rendering it worthless. Government bonds have minimal default risk.
Types of Bonds
The major categories of bonds include:
- Treasury bonds - Issued by the federal government and considered one of the safest investments since they are backed by the full faith and credit of the US government.
- Municipal bonds - Bonds issued by state and local governments to fund public projects. Interest is tax-exempt at the federal level.
- Corporate bonds - Issued by companies and carry a higher risk of default. Credit ratings agencies assess each company's default risk.
- High-yield bonds - Also called "junk bonds", these have speculative credit ratings, but pay higher yields due to higher risk of default.
Bond Investment Strategies
Some approaches for investing in bonds include:
- Laddering - Maintaining a portfolio of bonds maturing at different dates. This provides constant access to principal and reinvestment at higher yields.
- Duration matching - Matching the duration of your bond portfolio to your investment time horizon to minimize interest rate risk.
- Bond funds - Allow small investors to gain diversified bond exposure. Categories include government, corporate and high-yield bond funds catering to different risk tolerances.
Bonds traditionally make up 10-30% of an investor's portfolio, but allocations depend on your specific goals and risk tolerance. Conservative investors may allocate 50% or more to bonds, while more aggressive investors may exclude bonds entirely. Revisit your bond allocation periodically and rebalance as needed.
Commodities refer to the basic agricultural and natural resource products that provide essentials for everyday life, commerce and manufacturing. The major commodity categories include:
- Precious metals - Primarily gold and silver which hold inherent value and work as inflation hedges.
- Industrial metals - Like copper, aluminum, uranium and lithium which are essential for construction and technology.
- Oil and gas - Include crude oil, natural gas and diesel which provide the world's core energy resources.
- Agricultural products - Such as corn, soybeans, coffee, sugar, and livestock like lean hogs and cattle.
Some benefits commodities offer investors:
- Diversification - Commodity prices are not closely correlated to stocks and bonds, making them key portfolio diversifiers.
- Inflation hedge - Rising commodity prices protect against inflation eroding the value of traditional paper assets.
- Growing demand - Development of emerging markets increases demand for food, energy and raw materials.
However, commodities also carry substantial risks for investors:
- Volatility - Commodity prices fluctuate wildly in short periods based on supply and demand shifts, weather, geopolitics and other factors.
- Speculation - Commodities frequently attract speculation driving rapid price spikes and crashes.
- Illiquidity - Physical commodities must be stored and transported, reducing liquidity compared to financial assets.
Commodity Investment Vehicles
Commodities can be invested in directly or through derivatives.
- Futures - A futures contract allows an investor to buy or sell a commodity at a predetermined price for delivery at a future date.
- ETFs - Commodity ETFs hold futures contracts on various commodities, providing exposure without direct investment.
- Stocks - Stocks of commodity producers provide indirect exposure to price movements. Examples include oil companies and mining stocks.
- Options - Options contracts allow investors to hedge commodity positions and limit downside risk.
Most mainstream investment advisers recommend limiting commodities to a small allocation of 5-10% of a portfolio, if at all, due to their volatility. However, commodities provide valuable diversification during stock and bond downturns. Conservative investors may exclude commodities entirely while more aggressive investors allocate up to 15% to commodities.
Real estate investing involves owning physical property or related assets, either directly or through vehicles like REITs. There are several routes to invest in real estate:
- Direct ownership - This involves personally purchasing investment properties like rental houses, apartments, land or commercial property.
- REITs - Real estate investment trusts allow investors to gain exposure to real estate without buying physical properties. REITs trade on exchanges like stocks.
- REIT funds and ETFs - Mutual funds and ETFs hold diversified baskets of REITs for broad, low-cost real estate exposure.
- Home ownership - For most Americans, their primary residence makes up the largest proportion of real estate investment.
Here are some of the unique advantages real estate offers as an asset class:
- Appreciation - Real estate values historically appreciate over the long run at a rate comparable or superior to stocks, providing the potential for equity buildup. Location and market conditions drive appreciation.
- Cash flow - Rental income from investment properties provides steady cash flow, similar to bond coupon payments. Strong tenants and long leases underpin cash flow stability.
- Tax advantages - Tax breaks including depreciation and 1031 exchanges help shelter rental income and capital gains from taxes.
- Inflation hedge - Property values and rents tend to increase alongside inflation, providing an inherent hedge.
However, real estate investing also involves major risks and downsides:
- Illiquidity - Physical property can take a long time to sell, limiting your ability to access invested capital. REITs provide much more liquidity.
- Capital intensive - A 20% down payment is typically required for financing investment property purchases through a mortgage.
- Downturn risk - Real estate is cyclical and vulnerable to economic declines when home prices and rents can fall.
- Management cost - Long-term costs like property taxes, insurance, maintenance and management fees impact returns.
Some other notes about investing in real estate:
- residential rental properties provide more stable income while commercial real estate offers higher potential returns
- if you already have a lot of your wealth invested in real estate via residential rental properties, you may want to keep your REIT holdings lower than other people, or at least invest more in REITs that hold less residential real estate. When thinking about diversification you should think about allocation per asset class and also highly correlated assets across asset classes.
Real Estate Investment Strategies
Some real estate investment strategies include:
- Rental properties - Owning residential or commercial rental property provides rental income and appreciation over the long-term.
- REIT investing - Building a portfolio of REITs provides broad exposure to the real estate sector along with dividends and liquidity.
- Fixer-uppers - Purchasing undervalued properties in need of repairs, renovating them, then selling for a profit.
- House flipping - Buying underpriced properties, holding short-term, then selling them quickly once values increase.
- New construction - Investing in new real estate developments and housing projects provides exposure to growing markets.
Real Estate Allocation
Many experts recommend allocating 10-20% of investment assets to real estate for most investors. Conservative investors may exclude real estate entirely or restrict to their primary home investment. More aggressive investors may allocate up to 30% into real estate. Periodic rebalancing helps maintain your target allocation.
Exchange-Traded Funds (ETFs)
Exchange-traded funds have seen explosive growth in popularity over the last decade. ETFs provide investors with diversified exposure to market indexes or specific sectors at a very low cost compared to most mutual funds.
ETFs share some key features:
- Diversification - Most ETFs hold dozens or hundreds of underlying securities, reducing company-specific risks.
- Low costs - ETFs have minimal management fees since they are passively managed and do not require high-cost stock picking.
- Liquidity - ETFs trade throughout the day on exchanges just like stocks, providing continuous liquidity.
- Transparency - ETF holdings are disclosed daily, allowing investors to know exactly where their money is allocated.
- Flexibility - ETFs provide exposure to a growing array of asset classes, indexes, sectors, and strategies.
Some risks associated with ETF investing include:
- Underlying assets - While diversified, ETF performance is ultimately dependent on the returns of the assets held.
- Tracking error - The ETF return may diverge slightly from the index it tracks due to fees and other factors.
- Trading costs - Brokerage fees apply when buying and selling ETF shares, reducing net returns.
- Tax efficiency - Returns can be eroded by capital gains distributions from frequent ETF trading.
Major ETF Categories
Some of the most popular types of ETFs include:
- Stock ETFs - Track indexes like the S&P 500 or specific sectors like energy, technology or healthcare companies.
- Bond ETFs - Hold a range of government, corporate and other bond types in one fund.
- Commodity ETFs - Provide exposure to broad commodity indexes or single commodities like oil, gold or natural gas.
- REIT ETFs - Hold a basket of real estate investment trusts to add liquid real estate exposure.
- Dividend ETFs - Track indexes focused on stocks with high dividend yields.
- Active ETFs - A minority of ETFs are actively managed like mutual funds, but maintain tax efficiency.
ETF Investment Approaches
ETFs can be utilized in most portfolio approaches including:
- Core holdings - Large ETFs like SPY and VTI tracking total stock markets can form the core of passive portfolios.
- Satellite holdings - More specialized ETFs focusing on specific sectors, factors or commodities can supplement core holdings.
- Indexing - Replicating major indexes like the S&P 500 using ETFs allows low-cost index investing.
- Asset allocation - ETFs provide an inexpensive way to implement precise asset class exposures within an allocation strategy.
- Tactical tilting - Rotating between ETFs targeting different styles, sectors, or countriesexpected to outperform.
ETFs can fill multiple roles in a portfolio, making them highly customizable. ETFs are well suited to comprise 50% or more of long-term investment portfolios, especially for passive index investors. More active stock pickers may restrict ETFs to 10-30% of assets. It depends on your investment philosophy and implementation preferences.
Crafting Your Asset Allocation Strategy
The optimal asset allocation for your investment portfolio depends on your specific goals, time horizon, and risk tolerance. Your asset allocation should reflect your unique situation and priorities.
While there are general guidelines for allocating among stocks, bonds, and other asset classes, your exact allocations should be customized based on factors including:
- Your age - Younger investors may allocate more heavily to stocks for growth, while older investors emphasize income and capital preservation with more bonds.
- Time horizon - Your investing time frame affects how much volatility you can handle. Longer time horizons support more stocks.
- Risk tolerance - How much volatility in returns can you stomach? Conservative investors allocate more to stable assets like bonds.
- Investment objectives - Growth-oriented investors favor stocks, while income investors focus on bonds, dividends, and rentals.
- Asset location - Tax-advantaged accounts like 401(k)s can hold taxable investments like REITs and commodities.
Here is one example of a portfolio allocation across the major asset classes discussed:
- U.S. stocks - 40%
- International stocks - 20%
- U.S. bonds - 20%
- International bonds - 5%
- Commodities - 5%
- REITs - 5%
- Cash - 5%
This provides broad diversification across multiple asset classes, both domestic and international. The exact percentages should be tailored to your situation.
It's also critical to rebalance your portfolio over time back to your target allocations. As various assets appreciate faster than others, rebalancing involves selling assets that have outgrown targets and reallocating back to underweighted assets. This allows you to buy low and sell high.
The Bottom Line
Constructing a properly diversified investment portfolio is crucial to long-term performance. By spreading assets across uncorrelated asset classes like stocks, bonds, commodities, and real estate, investors benefit from diversification while reducing portfolio risk and volatility.
Finding the right mix of investments to match your goals and risk tolerance provides an optimal balance of risk versus return. Conservative investors overweight stable assets like bonds, while more aggressive investors take on more risk with higher stock allocations. Combining active and passive approaches through individual asset selection alongside index funds and ETFs offers additional diversification benefits.
No single asset class consistently outperforms. By diversifying holdings across multiple asset types and strategies, a well diversified portfolio can target impressive risk-adjusted returns over the long run. Just be sure to revisit your asset allocation periodically and rebalance to stay in line with your original investing goals and risk levels because over time dividend reinvesting may make your allocation to one sector or asset class more overweight than others due to recent outperformance. With the right mix of asset classes and diversification across sectors, your portfolio can navigate any market environment.