Most investors place a high value on diversification or selecting different asset classes to reduce portfolio risk. Despite this, even portfolios with well-diversified holdings can face broad market risks, also known as systematic risks.
Even the best diversified single-asset class portfolio is subject to broad market risk. In other words, adding more stocks doesn’t reduce the risk associated with holding a highly diversified equity portfolio.
To understand what asset classes you should own to diversify your portfolio, let us answer, “What are asset classes?” in the next section.
Table of Contents
- 1 What Are Asset Classes?
- 2 Which Asset Classes Are Most Popular and Why?
- 3 Why Is Diversification Important in Investing?
- 4 How Many Stock Positions Are Best?
- 5 What Are the Different Types of Risk?
- 6 Are There Any Reasons I Shouldn’t Diversify My Portfolio?
- 7 What’s the Difference between a Diversified Equity Portfolio and a Diversified Portfolio of Different Assets?
- 8 How Should I Diversify My Portfolio?
- 9 Diversification and Your Portfolio
What Are Asset Classes?
Asset classes are groups of investments with similar attributes and characteristics. The term asset class refers to a group of investment instruments that have similar characteristics in the marketplace, including:
• Investments within an asset class may be regulated and governed by the same laws.
• Stocks (equity), bonds (fixed income, debt), cash/cash equivalents, currencies, real estate, and commodities are asset class types.
• Typically, there’s little or a negative correlation between asset class groups.
That’s why professional investment advisors urge their clients to diversify. Simply put, “it’s never wise to put all your eggs in one basket.”
Understanding “Asset Class”
An asset class is a like set of financial instruments. For instance, GE, IBM, and AAPL are publicly traded shares of General Electric, IBM, and Apple. Collectively, they’re stocks. Stocks, or equities (which can be from US based or foreign companies ) are an asset class.
Stocks, bonds, and cash equivalent instruments are historically popular with U.S. financial market investors. Today, many investors also include foreign exchange, cryptocurrencies, digital assets, real estate, futures, derivatives, or commodities to diversify their asset class mix.
It is possible to hold this kind of asset within a retirement plan, check our guide what assets you can hold in a SDIRA to know more.
Some investors like to include intangible instruments like financial securities that trade on an exchange with tangible assets like real estate or precious metals. Note: Although it’s possible to acquire and sell tangible assets for the purpose of generating capital gains or income, investors may bear what’s called liquidity risk.
Each asset class category is supposed to provide different risk-return characteristics. For that reason, asset class diversification can help maximize your portfolio return in any given market environment.
Investing in a variety of asset classes reduces risk as it increases the probability of achieving long-term portfolio profits.
Investing Strategy and Asset Class Selection
Your investing strategy may focus on value, long-term growth, income, or a balance of factors. Some reliable valuation metrics for stocks, e.g. EPS (earnings per share, or P/E ratio), don’t apply to fixed income vehicles like bonds.
The most popular asset classes have two common characteristics:
• Stocks, bonds, cash/cash equivalents, and commodities are highly liquid asset classes. It’s possible for investors to find ready liquid markets for these asset classes most of the time.
• These assets are the most often quoted. These asset classes are the most liquid because market makers stand ready to acquire and sell stocks, bonds, money market instruments, and similar investment vehicles.
Keep in mind that the liquidity of an asset doesn’t reflect the possibility of high returns. Illiquidity of an asset means that it isn’t traded in a public forum.
More time may be required to identify future acquirers when the holder wants to trade the tangible asset for cash. If an investor needs to convert a valuable collectible on short notice, they may need to sell at a discount.
Which Asset Classes Are Most Popular and Why?
The U.S. equity market has demonstrated its long-term wealth-building capacity. It’s outpaced all other asset classes over time.
The S&P 500 compounded annual growth rate (CAGR) is approximately 7.6 percent:
• One hundred dollars invested in the S&P 500 in 1922 is worth almost $200,000 in 2022 (adjusted for inflation).
• Without considering the impact of inflation, the value of $100 invested in 1922 would be worth more than $2 million today!
• In comparison, one hundred dollars invested in 10-year U.S. Treasury bonds would have grown to just $8,000.
Why Is Diversification Important in Investing?
Diversification is a way to reduce portfolio risk by distributing investment dollars in a variety of financial instruments, categories, and industry groups.
The goal of diversification is to maximize portfolio returns. Historically, asset classes react differently in the same market conditions or events.
Many investment advisors believe that, although diversification can’t guarantee your portfolio against loss, it’s a time-tested way to achieve long-term goals and lessen some risks:
• Diversification spreads risk: by investing in an array of financial instruments, categories, and industry groups.
• Diversification can mitigate risk other than systematic or broad market risk. This type of risk is considered unavoidable.
• Balancing your diversified portfolio can be a complicated task. When broad markets rise, your portfolio returns may be lower because diversification also mitigates risk.
An Example of Portfolio Diversification
Imagine that your portfolio is invested in only publicly traded airlines. Prices of airline equities drop after fuel cost rises and fewer people get airline tickets. An extended pilot strike results in many more canceled flights.
When the news about airline stocks is bad, your portfolio loses value.
To offset the potential impact of fewer air travelers, you might decide to own shares in another industry group. In fact, if you choose manufacturers of leisure vehicles, the value of these shares may go up as more people choose camping over air travel.
To diversify your portfolio, select stocks in other industry groups. For instance, rising fuel cost might affect both industries. You might choose financial technology shares because this industry group doesn’t correlate with airlines or leisure vehicle manufacturers.
To improve your portfolio’s diversification:
• Select as many different industries and companies as possible to ensure that your holdings aren’t correlated in an equity portfolio.
• Diversify your portfolio holdings among other asset classes, e.g. bonds. Bonds don’t react like stocks to certain adverse news or events.
• Combine asset classes, e.g. shares and bonds, to lower your portfolio’s overall volatility. This diversification protects you from market swings.
• Diversification into other financial markets can also aid your portfolio. Discuss this type of diversification if it interests you.
How Many Stock Positions Are Best?
Logically, owning a half dozen stocks is preferable to owning only one. How many funds and therefore equity positions should you have to diversify your portfolio?
Financial professionals argue about how many security positions you need to optimally reduce risk and achieve high returns. Many say it’s possible to adequately diversify with just 15 to 20 stock positions in your equity portfolio.
Mutual funds are ideal investments for many portfolios. The best mutual funds bring liquidity, diversification, and professional management.
To get started, see our guide about common mistakes to avoid when investing in mutual funds or the advantage of no-load mutual funds. You might want to check our article called asset-based fees: are they worth it as well.
What Are the Different Types of Risk?
As you know, an investor faces two primary types of risk. The first is market risk. Market risk includes the impact of inflation rates, interest rates, political unrest, war, and exchange rates.
Market risk isn’t tied to any industry or company, and it’s impossible to eliminate or reduce it by diversifying your portfolio.
Investors must learn to accept market risk. That’s because market risk touches the broad financial markets in their entirety. It’s not limited to a type of investment category, industry, or vehicle.
Unlike market risk, some secondary risks are specific to a country, company, economy, industry, or marketplace. The sources of secondary risk include financial risk and business risk:
• You can limit exposure to secondary risk by diversifying your portfolio.
• Investing in a variety of assets allows you to spread secondary risk. Not all assets in a diversified portfolio will react in the same manner to market events.
Are There Any Reasons I Shouldn’t Diversify My Portfolio?
Financial advisors know the importance of diversification to protect their customers’ capital. There are downsides to diversification for some investors, however, including:
• Management of a diversified portfolio can be challenging or cumbersome for the new investor.
• A diversified portfolio may be more costly to maintain. Buying and selling various investment vehicles can affect bottom-line results. Transaction costs can limit your upside returns.
• Complex transactions aren’t suitable for everyone. Synthetic products were designed to add leverage that magnifies the investor’s profit or less. These products simply aren’t intended for small or new investors. It’s possible to suffer a 100 percent loss of capital or more in these products.
Know your risk tolerance level. If you have limited experience and investment capital, consider professionally managed and diversified mutual funds. If you want to build a portfolio, start with the classics, e.g. stocks, bonds, and cash equivalents like Treasury bills and money market funds at the start.
Remember that even the best financial analysts can’t guarantee a company’s earnings results. They can’t predict poor management decisions or broad market declines.
That’s why diversification won’t prevent you from losing money but it can lessen the impact of secondary market risks.
Diversification can also help to lessen your portfolio’s volatility. Recognize that even an ideally diversified portfolio can never completely eliminate some risks.
It’s possible to reduce the risks associated with specific stocks but the risks associated with the broad market affect almost all companies’ shares on an exchange.
Diversify your portfolio (according to risk tolerance) between different asset classes, e.g. stocks, T-bills, bonds, cash, real estate, etc.
Low Correlation between Asset Classes
Look for assets with low correlation ratios. A low correlation lessens portfolio volatility.
When volatility in your portfolio is reasonably low, the value of your assets rise or fall at different rates and at different times.
The reasons your asset values change are based on many factors. For that reason, a portfolio built with diversified assets can improve your portfolio’s performance.
Correlation is easy to understand. Let’s say that two asset classes, A and B, are correlated. Their correlation is +1. In other words, when A moves up or down, B moves with A by the same amount.
If you’re adding asset classes to diversify your portfolio, that’s not what you’re after.
Instead, if A and B move in direct opposition to each other—if A goes up, B goes down by an equal amount and vice versa, they demonstrate a negative correlation (-1).
What’s the Difference between a Diversified Equity Portfolio and a Diversified Portfolio of Different Assets?
When we discuss the importance of diversification in any equity portfolio, we consider the investor’s desire to lessen exposure to any company-specific or industry-specific risks by investing in a variety of companies in different industries, sectors, or geographies:
• A diversified equity portfolio includes a variety of stocks—but it contains a single asset class.
• Diversifying a portfolio to include other asset classes broadens the concept of diversifying your stock holdings. By adding a variety of investments across an array of asset classes, you reduce systemic risk exposure to any asset class.
• If the broad market sells off and the value of stocks in your portfolio decline, other assets that aren’t correlated to equities might not decline in value at the same time. Including a variety of asset classes can provide additional portfolio stability.
• Avoid putting all of your capital into any asset class basket. If you invest in just one asset class, e.g. stocks, and you diversify the stocks in the portfolio, you’re still vulnerable to market risk.
• Invest in a variety of assets to reduce market risk exposure or the specific systemic risk associated with any asset class.
Diversification can’t guarantee that you won’t lose money. However, financial advisors view diversification as a time-proven long-term investment strategy.
How Should I Diversify My Portfolio?
Should I Invest in Fixed Income Securities?
Historically low coupon rates on bonds have prompted some investors to delay their investments in bonds. However, in a rising interest rate environment, it may be prudent to diversify in fixed-interest assets as a way to diversify your portfolio:
• U.S. Treasury bills (T-bills), certificates of deposit (CDs), and bankers’ acceptances are popular ways to invest in fixed income.
• Because these instruments have fixed interest and short maturity dates, they’re less risky than securities.
• Fixed interest investments have a low correlation to stocks.
• In contrast, high-quality fixed interest investments provide lower returns than equities.
Should I Invest in Real Estate?
Low mortgage loan rates and housing supply across the nation have attracted many investors to real estate investments. Consider that:
• Some real estate is a practical addition to your portfolio if you’re seeking more diversification.
• If you own a home, you’re a real estate investor. You can invest in real estate through real estate investment trusts (REITs) as another way to own real estate. Look for publicly-traded REITs if liquidity is important to you.
• Many REITs provide higher than market yields. These investments can add to your portfolio income.
• Real estate’s correlation to stocks is reasonably low.
Do I Need “Safe-Haven” Assets?
A “safe-haven” asset is one that provides stability to the diversified portfolio when market instability or turmoil occurs. Some safe havens include precious metals, e.g. gold, silver, platinum, etc. These iconic stores of value aren’t tied to market indicators, e.g. interest rates.
Not all investors see gold or other precious metals as safe-haven assets. However, gold has historically demonstrated its ability to maintain value over time. It may be useful in hedging the portfolio against the ravages of inflation and other negative market conditions.
Should I Invest in Currencies?
Currencies, usually considered the fiat currencies of sovereign nations, may be an important component of your portfolio diversification strategy.
While some view cash as an essential currency holding, it’s not usually advisable to keep funds in cash over long periods. Cash has no yield or upside return and, when inflation is present, negative returns over time are likely.
How Many Stock Positions Do I Need to Diversify My Portfolio?
There’s no “magic number” of equity positions needed to diversify your portfolio. However, a portfolio with multiple stock positions is naturally more diverse.
Some things can affect the diversification of your portfolio, including:
• Instrument quality (e.g., the quality, size, or financial strength of the company)
• Sector quality (e.g., prospects for the sector)
Diversify your portfolio to include other asset classes. Your equity portfolio, no matter how well diversified, still represents a single asset class.
Is Over-Diversification Possible?
Yes. Your portfolio can become over-diversified if the addition of investments decreases the overall expected return to a greater degree that it reduces the portfolio’s risk profile.
Should I Invest My Portfolio in All Stocks?
A long-term bull market can tempt some investors to declare, “Bonds don’t matter. Should I invest 100 percent of my capital in stocks?”
It’s probably never a good idea to invest all your money in any one asset class.
Financial markets rise and fall. All portfolios are potentially vulnerable to market gyrations. Adding more asset classes, e.g. Treasury bills, precious metals, bonds, and real estate, can help you to withstand a market downturn.
Diversification and Your Portfolio
The answer to how many asset classes you should own to achieve a truly diverse portfolio depends on multiple factors.
Your investment life cycle stage, risk tolerance, and willingness or ability to manage different investments across asset classes are some of the factors to consider with your financial advisor.
Diversification is one of the keys to building a resilient financial plan. Using diversification can help you to prepare for upside returns while managing systematic and secondary risks.
Financial markets will rise and fall. Anticipate and prepare for market downturns. Regardless of how much capital you have to invest, use diversification as part of your long-term wealth-building strategy.