When investors hear the term “diversification,” they may assume it simply means spreading their investments into different asset classes, such as having 70% of their investments in stocks and 30% in bonds.
This is the most basic type of investment diversification, but there are a number of ways to diversify that investors should consider.
Below are answers to common questions about diversification that help explain why diversification is important and how you can help ensure your portfolio is appropriately diverse.
Q: What is investment diversification?
A: Diversification essentially means avoiding the potential mistake of putting all your financial eggs in one basket. Tracie McMillion, CFA®, Head of Global Asset Allocation for Wells Fargo Investment Institute, explains that rather than putting all of your money in a very limited number of investments, you may need to spread your money over a number of different stocks, bonds, cash alternatives, and other asset types.
Q: What kinds of investment types should I include in a diversified portfolio?
A: The primary classes to 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 may not be quite enough.
Q: What additional types of diversification are there?
A: The major types of diversification to consider 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 or emerging markets.
- Company-size diversity: Companies are grouped into large-, mid-, and small-cap (for capitalization) stocks. Large-cap companies have a higher total market value (over $12.5 billion); mid-cap companies have moderate total market capitalizations; and small-cap companies have capitalizations on the lower end. Depending on your goals and risk tolerance, you may want to have a variety of large-, mid-, and small-cap stocks or 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 real estate. 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. It may be easier to determine 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, because 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.”
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 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 three or four similar funds, you may not be 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.