Portfolio diversification is the investment equivalent of eating a balanced diet. In the same way that maintaining physical health requires eating a wide variety of foods to ensure proper nutrition — and not overdoing it on any one food — making sure your investment portfolio contains exposure to a broad mix of asset classes has proven over time to be the best way to maximize performance while minimizing risk.
Introduction to portfolio diversification
Many investors long have sensed the value of portfolio diversification, which essentially follows the folk wisdom that it’s not a good idea to put all your eggs in one basket. But it was not until 1952 that the idea was recognized academically. That year, economist Harry Markowitz published a research paper, “Portfolio Selection,” in “The Journal of Finance” showing that if an investor built a portfolio of many uncorrelated assets they would achieve better returns with less risk due to diversification. Along with economists Merton Miller and William Sharpe, who developed what is known as the Sharpe ratio in 1966, which compares the return of an investment with its risk, Markowitz won the Nobel Prize in economics in 1990 for his work on what has become known as modern portfolio theory (MPT).
What portfolio diversification means
A diversified portfolio consists of investments in a variety of asset classes, each of which has different characteristics and risks. The asset classes within a diversified portfolio also should be uncorrelated or minimally correlated to on another, meaning that when the performance of one zigs, the others zag or move only slightly in the same direction. Major asset classes include:
Equities: Representing an ownership stake in a business, equities are considered one of the more risky asset classes. Equities can be held directly by buying shares in a corporation traded on a stock market or owning a partnership interest or shares in a privately held company. A company’s shares also can be owned indirectly through an equity mutual fund or an equity exchange-traded fund (ETF), two types of pooled investment vehicles, which serve to diversify an investor’s equity holdings. The portfolio advantage of equities is that companies have the potential to grow and become more profitable, which increases their value and typically results in higher share prices and bigger dividends over the long term. The risk in owning equities is that a company may not perform well or go out of business, which means an investor can lose everything he or she invested.
Bonds: When you borrow money in the form of a mortgage, car loan or student loan, for example, you are a debtor and have to repay what you borrowed with interest. When you buy a bond issued by a company, the US Treasury or a state or municipality, you are, in effect, a lender; the bond issuer owes you money, plus interest. Bonds generally are conservative investments. They are considered less risky than equities and act as ballast in a diversified portfolio because an investor knows in advance what they will receive if they hold their bond to maturity — essentially, whatever amount they invested plus interest. The chief risk in owning bonds is credit risk or the possibility that the issuer won’t be able to repay their debt. Bond credit-rating agencies assign ratings to bond issues based on their assessment of the issuer’s creditworthiness. Corporate bonds are either investment grade, which have a low chance of default, or high yield, which pay more interest but have a greater risk of default. US Treasury bonds (issued in 20- and 30-year durations) and notes (which mature in two, three, five, seven or 10 years) are the least risky investments. Bonds can be purchased individually or through a bond mutual fund or ETF, which can be broad or narrow in its focus.
Cash: This is considered the least risky asset class and includes money that doesn’t earn interest (currency and, often, checking account balances) as well as interest-earning savings accounts, certificates of deposit (CDs), money market funds and Treasury bills (which mature in one year or less) that are extremely liquid and can be turned into currency very quickly.
Other asset classes, sometimes grouped as “alternatives,” include:
Commodities: These are the raw materials and building blocks of the economy: oil, natural gas, agricultural goods, metals and minerals. Since the prices of commodities rise directly with demand, and because their prices ripple through the economy, buying commodities directly or indirectly (through ETFs, for example) is seen as a way to hedge against inflation.
Real estate: Buildings of all types — residential, retail, industrial/commercial and office — are long-lasting assets that are illiquid. This means they cannot be bought or sold quickly, making each asset’s price more difficult to determine. These qualities, however, also make real estate valuable as a portfolio diversifier, since its components have varying degrees of correlation to other asset classes. While real estate assets themselves are typically illiquid, many have been packaged in liquid structures, such as real estate investment trusts (REITs) and real estate mutual funds and ETFs, that permit investors to easily buy and sell fractional interests in real estate.
Private equity and hedge funds: These are often illiquid investments in privately owned companies or investments in trading strategies that have considerable risk but the opportunity for sizable gains. Because of the risk, investments in these asset classes often require investors to be considered “accredited” by the Securities and Exchange Commission (SEC), meaning an investor has a net worth over $1 million, excluding their primary residence. Accredited investors also must have individual income of $200,000 or more, or combined income of $300,000 or greater with a spouse or partner, in each of the prior two years and should reasonably expect that same level of income in the current year.
When Markowitz developed his theory in the 1950s, true portfolio diversification could be achieved only by extremely wealthy individuals or by huge institutional investors, such as insurance companies, because only they had enough money to invest in a broad enough array of stocks, bonds and real estate investments to be truly diversified. The expansion of mutual funds and ETFs over the years has enabled investors of modest means to achieve portfolio diversification by affording them the ability to buy small fractional stakes in a wide variety of investments and asset classes.
| Asset Class | Pros | Cons |
|---|---|---|
Equities | Equities typically make up the largest portion of a diversified portfolio, as they have the potential to increase in value, resulting in higher share prices and bigger dividends over time. | If a company does not perform well or goes out of business, an investor can potentially lose their entire investment in the company. |
Bonds | Bonds are essentially loans given to governments or companies, which act as ballast in a diversified portfolio because an investor knows in advance what they will receive if they hold their bond to maturity. | The chief risk in owning bonds is credit risk or the possibility that the issuer won’t be able to repay their debt. |
Cash | Cash and cash equivalents, such as CDs, money market funds and Treasury bills, are liquid assets that typically make up a small portion of a diversified portfolio. | Cash and cash equivalents typically don’t return as much as other types of investments. |
Commodities | Commodities rise and fall according to supply and demand and can potentially act as a hedge against inflation. | Outside of a diversified portfolio, commodities generally come with greater levels of volatility than other asset classes. |
Real estate | Real estate is a valuable portfolio diversifier since its components have varying degrees of correlation to other asset classes. | Traditional real estate assets are highly illiquid and can be difficult to properly value outside of investing in REITs and funds. |
Private equity and hedge funds | Private equity and hedge fund investments can add diversification to a portfolio and come with high reward potential. | They also come with higher levels of risk and are therefore typically restricted to accredited investors. |
The benefits of portfolio diversification
The reason portfolio diversification works is because the future direction of the economy and securities prices are unknown. Since the prices of stocks, bonds and other assets reflect what people think about the future at a specific moment in the present, the value of those assets keeps fluctuating as new information about the economy comes to light.
For example, if people start to expect better times ahead, they typically are willing to pay more for the shares of companies they expect will do well, and the prices of those securities will tend to rise. If bond investors expect higher interest rates ahead, they will start to demand a higher return on the bonds they are buying, which in the bond market translates into lower prices.
Historically, the annual performance of different asset classes has fluctuated greatly, as seen here in a table prepared by pension consulting firm Callan. Sometimes, an asset class that returns the most in one year is near the bottom the following year. Since no one in a complex global economy such as ours can know what lies ahead and which asset class will benefit most or least from the coming changes, it’s better to effectively hedge one’s bets and diversify one’s holdings.
Research by Morningstar, a financial services firm, shows that for the 20 years that ended in 2021, a diversified portfolio outperformed a basic 60% stock-40% bond portfolio, returning an annualized 8.6% versus 8.1% for the 60/40 portfolio. In the most recent three-, five- and 10-year periods that ended in 2021, however, the 60/40 portfolio — while somewhat riskier — performed better, largely due to the outperformance of stocks and bonds during those periods and weaker results for other asset classes.
How to build a diversified portfolio
For the typical individual investor, building a diversified portfolio has never been easier due to the emergence of low-cost index mutual funds and ETFs. Index funds, which are bought and sold through mutual fund companies, and ETFs, which are bought and sold through the stock market, represent pools of securities that track the stocks or bonds that comprise a particular stock or bond index. Investors can buy ETFs or index funds that represent each asset class to build a diversified portfolio, but determining how much each asset class should constitute of the total is where things get tricky.
Traditionally, a portfolio consisting of a 60/40 mix of stocks and bonds has been considered diversified, although the addition of cash and “alternative” assets would make it truly diversified and lower its risk. A 60/40 mix also fails to take an investor’s age into account. Since it makes sense for younger investors to take more risk than older investors, because they have more time to make up for losses, many financial planners recommend that as clients age they increase the percentage of a diversified portfolio allocated to bonds, while keeping equities in the portfolio because retirement is now usually a longer phase of life than most people anticipate.
One very simple model for portfolio diversification is to buy just three funds — one that represents US stocks, one for international stocks and one for bonds. An investor could make that more granular by adding, say, a 5% allocation to a broad real estate fund and 5% to a high-yield savings account or short-term Treasury bills that would serve as a proxy for cash.
A final point: Portfolio diversification only works if you stick with it. Market booms and crashes can lead investors to make emotional buy and sell decisions that can derail long-range plans. Rebalancing portfolios once a year makes sense — that is, bringing the portfolio back into its original balance by shifting some allocations from a sector that did very well in the past year and increasing its share of the total to a sector that did less well and shrank from its original allocation percentage. Aside from periodic rebalancing, however, a largely set-it-and-forget-it approach, with a tilt toward conservative investments as one grows older, may be the least complicated approach to portfolio diversification.
Frequently asked questions (FAQs)
The chief downside to portfolio diversification is that, during times when a particular asset class is booming, a diversified portfolio will do less well than one concentrated in the booming sector. If the stock market is up by double-digits, for example, a portfolio with a significant portion of its holdings in bonds may be up only in the single digits, leading some diversified investors to feel they have been too cautious. Many will feel otherwise, of course, in a year if stocks decline significantly and their portfolio is down only a little or not at all.
Since no one has ever accurately predicted market performance with any consistency, the safest course of action is to hold a portfolio that contains as many asset classes as possible, such that when one asset class declines in value another is likely to rise. Sticking with a diversified portfolio also tends to keep an investor from succumbing to emotion and buying high during periods of market euphoria and selling low during panics. Consistency of even average returns over the long run and sticking with an investment program through upturns and downturns has proven to produce better overall results than trying to time the market.
The economy is a backdrop to markets, which serve as a pricing mechanism for investors’ expectations. If investors expect the economy to grow, they are said to be “risk-on,” which means they are likely to bid up the prices of riskier assets, including equities and high-yield bonds (also known as junk bonds). If investors are “risk-off” and expect a more difficult economic environment ahead, they are likely to seek shelter and safety in virtually risk-free government bonds, which drives bond prices higher and their yields lower. Having a diversified portfolio enables an investor to benefit from whatever happens in the economy, or at least not be harmed as much as would occur if they invested heavily in sectors that suddenly became unpopular.
Since consistent, long-term investing is the key to building wealth, one can generally use a set-it-and-forget-it portfolio diversification strategy, but with two caveats.
First, the portfolio should be rebalanced every year, if necessary, so that a component of the portfolio that has outperformed is reduced to its original share of the total, while a component that has underperformed is returned to its desired allocation.
Second, allocations should be adjusted for age, with bond allocations, which provides ballast to the portfolio, increasing somewhat as an investor ages and enters retirement. Most financial planners, however, still recommend that investors don’t abandon equities fully as they grow older since one’s non-working years may last 30 years or longer, requiring portfolio growth as well as income.
