How to diversify your portfolio to limit losses and guard against risk

Clint Proctor

Nov 14, 2020, 02:36 IST

How to diversify your portfolio to limit losses and guard against risk

Investors need to consider their tolerance for risk and investment time horizons when diversifying their portfolios.vitapix/Getty Images

Diversifying a portfolio means owning a mix of investments within and across asset classes to reduce exposure to risk and volatility.
To build a diversified portfolio, you'll need to consider your risk tolerance, time horizon, and investing goals.
Mutual funds and ETFs are prime diversification tools, offering instant access to hundreds of stocks or bonds as well as alternative investments like commodities or real estate.

There's a reason manufacturers make different product lines, and stores carry a range of goods: It protects their profits. If one item suffers a seasonal decrease in demand or is an outright flop, they may still be ok if the majority of the other items do well.

It's a business strategy called diversification. And just as diversification is important in industry, it's important for your investment portfolio as well.

The primary goal of diversification isn't to maximize returns; it's to limit risk. When you diversify your portfolio, you reduce your risk of experiencing massive losses when a few of your investments underperform. Read on to learn more about the benefits of diversification and for a step-by-step guide to diversifying your own portfolio.

Understanding risk

At its most basic level, risk refers to the chances that a particular investment or portfolio could suffer financial loss. Beyond this definition, risk can be broken into multiple categories:

Company risk: What is the financial strength of the company or government entity that you're looking to invest in (often through stocks) or loan money to (often through bonds)? Does it have a low, moderate, or high chance of bankruptcy?
Volatility risk: On average, how often does the particular asset that you're looking to invest in have losing years? For example, large-company stocks lose money once every three years on average.
Liquidity risk: How easy would it be to get your cash back out of the investment if you needed the money to cover an emergency expense?
Interest rate risk: How would your investment be impacted by a rise or fall in interest rates? Bond values, for example, tend to go down as interest rates go up.
Inflation risk: Is your portfolio's rate of return at risk of being outpaced by inflation? This could be a legitimate possibility for portfolios that are invested solely in cash equivalents.

All investments involve some level of risk.

If safety is your ultimate goal, however, look to bank or credit union deposit accounts (savings accounts, CDs, money market accounts, etc.). Since these accounts are insured up to $250,000 by the federal government, they offer the closest thing to an investment "guarantee."

How diversification benefits you

Diversification involves owning a mix of investments to reduce risk and volatility. Here a few common ways to diversify:

Company diversification: Owning shares of multiple companies so that your portfolio won't be significantly harmed if one stock declines or goes bankrupt.
Industry diversification: Owning stocks from a variety of industries (technology, healthcare, energy, consumer staples).
Size diversification: Investing in companies of different sizes, or market caps, such as small-cap, mid-cap, and large-cap companies.
Global diversification: Investing in a mix of domestic and international stocks
Asset class diversification: Moving beyond stocks and bonds, the traditional financial assets, to invest in additional types: real estate, commodities, private equity, and cash.

The more diversified your portfolio becomes, the less of a chance you'll have of experiencing a huge loss in any given year.

Downside to diversification

Unfortunately, with investments, the chance of big losses usually goes hand-in-hand with the possibility of big wins. Diversification's benefits often come at a cost: diminished returns.

To illustrate: a recent study, using historical data from 1970-2016, which compared the performance of three hypothetical portfolios:

Conservative: 30% stocks, 50% bonds, 20% cash
Moderate: 60% stocks, 30% bonds, 10% cash
Aggressive: 80% stocks, 15% bonds, 5% cash

If avoiding declines was your only goal, the conservative portfolio would be the clear winner. The maximum one-year loss it suffered was 14%, vs. 32.3% for the moderate, and a whopping 44.4% for the aggressive.

But when it came to annualized returns for each portfolio, the conservative gained 8.1%, the moderate, 9.4%, and the aggressive,10%.

Those slight differences may not seem like a big deal. But over a 40-plus year investment horizon, they add up. For example, if each portfolio had begun with $10,000, their final account tallies would have been:

Conservative: $389,519
Moderate: $676,126
Aggressive: $892,028

Riskier investments tend to offer higher potential returns. So, smoothing out the risks, as diversifying does, means no sickening drops — but no exhilarating lifts, either. Most investors are willing to accept the tradeoff.

How to diversify your investment portfolio

Ready to start building a diversified portfolio? Here are four diversification tips to guide you along the way.

1. Determine your risk tolerance

Your risk tolerance is how much money you are willing to lose in the short-term in exchange for the potential for higher long-term growth. There are various factors that can affect your risk level. These include your:

Time horizon: How soon will you need to take your money out of your investments? Someone who won't be retiring for another 30-40 years may be willing to take on more risk than someone with a retirement window of 5-10 years from now.
Income needs: If you're still working, you may decide to invest in higher-risk, growth-oriented investments. But if you've already reached retirement, you may prefer to focus on lower-risk investments that can provide a stable income, such as bonds, dividend stocks, and CDs.
Portfolio size: As your portfolio grows, you may choose to raise your risk tolerance since you'll have more capital available to sustain short-term losses.

The investments you select should be guided by your risk tolerance. Those with a high tolerance for risk may invest a large percentage of their portfolios in equities. Conversely, the percentage of bond and cash holdings will typically be higher for investors with lower risk tolerance levels.

How can you determine your risk tolerance? Many investing brokers and robo-advisor websites offer free risk- level questionnaires. Some will even offer asset allocation recommendations based on your answers. You can also work with a financial advisor or money manager to build a portfolio that's customized to your individual risk level.

2. Take advantage of mutual funds and ETFs

Once you've determined your risk tolerance, it's time to begin buying the investments that will comprise your portfolio. And it's at this stage of the game that baskets of securities such as mutual funds and exchange-traded funds (ETFs) can really come in handy.

Let's say, for sake of illustration, that you want an asset allocation of 70% stocks, 25% bonds, and 5% cash. To truly build a diversified portfolio with that asset allocation, you'd need to buy dozens (at the very least) of stocks and bonds. And for the stock portion of your portfolio, you'd also want to make sure that you were investing in companies of different sizes, industries, and geography.

Even if you had enough capital at your disposal to invest in such a diverse set of stocks of bonds, how would you go about choosing your individual investments? Most non-professional investors simply don't have the time that this kind of market research would require.

But by investing in mutual funds and ETFs, you can eliminate these problems. Funds make it easy to invest in hundreds or thousands of stocks, bonds, or alternative investments at once, even with limited capital (getting the variety of assets diversification requires can be expensive). And some mutual funds even offer a predetermined mix of stocks and bonds to serve as a "one-stop-shop" for all your asset allocation needs.

3. Consider moving beyond stocks and bonds

When financial professionals talk about asset allocation, they're often referring to your ratio of stocks to bonds. But it's worth noting that with both of these assets, your money is heavily invested in companies.

To increase your diversification, you may want to consider investing a portion of your portfolio in additional asset classes as well. For example, you may want to consider investing in raw materials by buying shares of a commodity mutual fund.

If you want to gain more exposure to real estate, you could invest in a real estate investment trust (REIT). Other alternative asset classes worth considering include private equity, collectibles (like stamps, art, or antiques), cryptocurrency, and hedge funds.

4. Regularly reevaluate your asset allocation

How do you know when you're properly diversified? The reality is that diversification is an ever-evolving process that will change as your time horizon shrinks.

To estimate your ideal asset allocation for your age, some experts recommend subtracting your age from 110 to 120. The result is the percentage of your portfolio that should be in stocks.

Using this rule of thumb, a 30-year-old would look to invest 80% to 90% of his or her portfolio in stocks, with the rest invested in bonds and/or cash equivalents. But an 80-year old would reduce his or her stock holdings to 50% to 60%.

The estimates above are just that...estimates. To determine your own ideal ratio, you'll need to take your specific financial situation and investment needs into consideration.

Even if your portfolio's asset allocation is perfectly matched to your age and needs, it can become out of alignment as certain assets outperform others. That's why it's important to monitor your portfolio and rebalance your original asset mix when necessary.

The financial takeaway

Investing is a game of risk and returns. Take on too much risk and you could lose big, especially in the short-term. Take on too little risk (like, say, by only investing in cash equivalents) and you could really hurt your long-term returns.

Diversification is the best way for investors to find their own personal balance of risk and reward. To build a diversified portfolio that works for you, consider your risk tolerance, time horizon, and investing goals.