Portfolio diversification is one strategy to manage overall risk by allocating across different asset classes, geographic regions, sectors and other factors such as style and market capitalization sizes.” It is akin to the idea of popcorn popping; when one investment declines, others may rise or at least act independently.

Nadine Terman of Solstein Capital explains how investment professionals generally agree that, even though diversification doesn’t guarantee loss protection, it’s still a key strategy to incorporate to attaining long-term financial goals by managing risk.

Why Diversify

Nadine Terman shares that everyone knows the saying “Don’t put all your eggs in one basket” and relates investment diversification to this old adage.  “When considering your nest eggs,” Nadine Terman explains, “you want to have a variety of independent and tactical baskets.”  The overarching reason to diversify is evident — protect against correlated losses–a characteristic that is especially important for individuals who must preserve wealth because of age, liquidity needs, or other key factors.

By reducing correlated losses, investors have a better chance to generate gains consistently over time.  Otherwise, a large drawdown in a portfolio could take a lot longer to come back from, when considering prudent risks taken after the fact to generate returns.  For example, if a portfolio declines by -20%, the resulting portfolio will have to generate 25% returns to get back to even. While investors may generate greater returns by concentrating into higher risk opportunities, they also could generate greater losses by doing so.

The question that still remains is: how should individuals diversify their portfolios?

Ways to Diversify Investment Portfolios

There isn’t a one-size-fits-all answer to portfolio diversification. Instead, individuals should work with an investment advisor to set objectives and craft a solution that works for them, incorporating their risk tolerances, risk capacities, liquidity needs, and other key factors.

There are various strategies to consider when proactively balancing portfolios (i.e., diversifying), three of which we outline below:

Consider Different Asset Classes

You’ve probably heard of 60/40 portfolios, whereby a portfolio allocation includes 60% in stocks and 40% in bonds.  This traditional allocation is based on the idea that stocks should delivered greater growth, but with more risk, than bonds which should have a lower downside but also a reduced return.  Nadine Terman of Solstein Capital cautions that there are periods when this strategy works very well for clients and periods when it absolute does not work for clients.  For example, in 2022, as central banks hiked interest rates quickly into an environment of stubborn inflation and peaking growth rates, as both stock and bond prices fell, creating drawdowns in such 60/40 portfolios across both asset classes.  Thus, Nadine Terman of Solstein Capital advises that individuals consider the macroeconomic environment expected for the next few quarters and years before determining whether asset class diversification could make sense for a portfolio.

Branch Out Across Industries/Sectors

Another diversification strategy to consider is sector and industry diversification.  Otherwise, even if a portfolio holds dozens of positions, they could be correlated –their prices could move in sync.  For example, it may seem counterintuitive but real estate stocks and utility stocks often move in the opposite direction of financial stocks because of the different impact interest rates has on each of the sectors.  So, concentrating in just more “defensive” sectors like the former could actually be increasing your risk.

Consider International Exposure

Diversification also could include geographic exposures.  While we may feel more comfortable investing in the US stock market, there are simple ways to invest in international exposures through securities such as ETFs that trade on US exchanges.  For example, if the US Dollar goes into a secular decline, investors could benefit from having emerging market exposure or even international gold exposure.  Because risk can occur at a country level due to changes in regulation, geopolitical events, monetary and fiscal policies, tax changes, investment liquidity, or other reasons, diversification should also consider different country exposure.

The Over-Diversification Concern

Sometimes investors take diversification to an extreme.  When constructing a portfolio, the individual elements should serve a purpose and matter to the portfolio.  It wouldn’t make sense to invest one penny in any investment, as even if it tripled, it wouldn’t matter to your overall returns.  So, it is important to consider not just why an investment should be in a portfolio, but the range of outcomes for that position.  That will help determine the size of the position and whether or not it deserves to remain in your portfolio