Diversification is a concept that the majority of investors understand on some level. It makes sense to not put all your eggs in one basket, but diversification is more than just investing in more than one fund or stock. Diversification is the basis of modern portfolio theory and it is an essential risk management tactic that every investor should be utilizing. Here’s how it works:
The measure of correlation indicates how closely two assets follow together when the markets go up and down. The scale of correlation goes from -1 to 1, with -1 being a perfect inverse correlation and 1 being a perfect correlation. For example, Oil Company A and Oil Company B will both fall if oil prices fall and they will both rise if oil prices rise. Therefore, they have a perfect correlation. Conversely, when Oil Company A rises, Automobile Company A will fall. This indicates an inverse correlation. If one companies rise and fall does not affect another company, then they have a correlation of 0.
The key to diversification is having varying degrees of correlation so that your portfolio is getting the most out of the market, while offsetting losses.
Picking a group of stocks that have varying degrees of correlation is a good place to start, but to truly diversify one must take on a variety of different assets. This is where asset allocation comes into play. Determined by risk tolerance and time horizon, holding a variety of different asset classes is the best way to curb volatility in your portfolio. Asset classes include stocks, bonds, commodities, mutual funds, real estate, real estate trusts… to name a few. Each asset class brings different risks to the table, so it is important to make sure you are thoughtfully choosing investments that complement one another and work well together.
Too much of a good thing isn’t a good thing at all, and that is especially true when it comes to diversification. It is possible to hold too many different investments that correlate in too many different ways. This might diversify the risk out of your portfolio and it may also stop you from making any gains. It is important to work with a wealth professional who can help you pick an appropriate amount of investment holdings while still utilizing an appropriate asset allocation so that you stay on track.
Understanding that you need to diversify your portfolio is not always enough as it can be a bit more intricate than it seems. That is why it is important to work with a financial planner that can help you understand how your investments work together to optimize your portfolio.