How diversification in investing may reduce risk

Generating competitive returns tends to be the dominant focus of many investors’ portfolio decisions. Yet just as important is the process of managing risk to limit potential losses; in periods of significant market downturns, managing risk tends to become a higher priority.

Maintaining a long-term investing strategy through volatile market periods typically requires a diversified investment approach. Investment diversification involves spreading your investment dollars among different types of assets to help temper market volatility. By “smoothing out” market performance, you may be more likely to maintain a long-term portfolio position, potentially improving your chances of meeting key investment goals.

As a simple example, all equity (or stock) investments and most fixed income (or bond) investments are subject to market fluctuation. Owning a mix of stocks and bonds usually helps limit short-term volatility. During periods when stocks are struggling, bonds may perform better, helping to offset the negative returns in stocks. At other times, stocks may significantly outperform bonds.

Different types of market risks to consider

It’s important to account for different types of market risks that could affect portfolio performance. These include:

• Interest rates. Changes in interest rates can affect the market value of holdings in your portfolio, particularly bonds. If rates decline, existing bond values rise. If interest rates increase, bonds held in your portfolio will lose value. “Changes in the interest rate shift prices for fixed income investments, either improving or diminishing total returns,” says Rob Haworth, senior investment strategist for U.S. Bank.
• Inflation. Changes in the cost-of-living can impact the investment environment and the net returns earned on investments after accounting for inflation’s impact. “Certain asset classes generally benefit more from a higher inflation environment,” says Haworth. “These include real estate and infrastructure firms.” Including such holdings in a diversified portfolio can help offset the volatility experienced by other assets during high inflation cycles.
• Market cycles. Broadly, a market cycle is the period between two market highs or lows, and it can last anywhere from a few months to several years. Market cycles are hard to pinpoint and sometimes fleeting, but they can have an impact on certain assets within your portfolio, depending on what’s fueling the cycle. Market cycles are caused by the development of trends within a sector or an industry. For example, during a market downswing, companies that supply staple goods, such as essential toiletries, may see growth in their stock prices.
• Government/central bank policy. Policy decisions regarding tax rates, government spending, trade and international relations can impact the investment environment. The direction of monetary policy established by central banks (such as the Federal Reserve) is another variable often reflected in the markets. “These policies often change the pace, trend or magnitude of economic and investment fundamentals,” according to Haworth.
• Global events. Global events such as the COVID-19 pandemic, natural disasters or geopolitical conflict can affect things like the supply chain, international trade and the global economy, as well as general investor sentiment and risk appetite—all of which can have an impact on stock prices.
• Currency movements. Those investing in foreign-based stocks or bonds could see results affected, either positively or negatively by currency movements. In general, if the value of the dollar versus other currencies, declines, it will benefit those with money invested abroad. If the value of the dollar rises, it can detract from net performance for U.S. investors. “This is an important, uncompensated risk for those who hold foreign bonds,” says Haworth. “For those with international equity positions, growth in earnings is generally considered sufficient to overcome currency risk.”
• Individual security. “It’s important to avoid adverse selection or investing a large percentage of your portfolio in a single security that proceeds to lose significant value in the market,” says Haworth. An overweight position in an individual stock is a particular risk for employees who put large sums of money into company stock or for families who have their wealth primarily tied up in their own company. “Trying to build wealth by directing most of your investments into a single company is taking on a lot of unnecessary risk,” says Haworth.
• Time horizon. The amount of time your money can remain invested will impact your diversification strategy. “The risk of loss is much more pronounced over any given one-year period, compared to holding it for ten years or more,” says Haworth. The longer you can remain invested, the greater the opportunity to overcome any temporary setbacks to your portfolio.

Three diversification approaches that may help mitigate risk

Building a diversified portfolio can help you manage risk. Here are three diversification approaches to consider as you make your investment decisions:

• Invest in a variety of asset classes. Stocks and bonds should make up most of your portfolio. However, within those broad classifications are a variety of asset categories. For example, stocks vary by market capitalization (small-cap, mid-cap and large-cap stocks). They’re also differentiated into growth or value classifications within each of those market capitalization categories. Bonds may include investment grade and below investment grade (junk) bonds, or municipal (tax-free) bonds. Haworth notes that lower-grade bonds often share performance characteristics with stocks, so they provide less diversification benefit to an equity portfolio than is the case owning high-quality bonds.
• Own assets representing different sectors. Within a stock allocation, diversification among a variety of industries can help mitigate risk. “If you own a concentration of technology company stocks,” says Haworth, “you really need to diversify your exposure around that.” If the technology sector lags the performance of other parts of the market, it will drag down the performance of your portfolio. This is true of other sectors as well. Positioning your equity portfolio across a broad spectrum of industry sectors can help smooth performance through different market environments.
• Include foreign investments in the mix. International stocks make up less than one-third of the world equity market’s value.¹ Diversifying into global stocks provides returns that tend to be differentiated from those of U.S. markets and benefits from economies that may be on a different growth path compared to that of the domestic economy. It opens up potential new opportunities to benefit from growth overseas.

Assess your own portfolio for investment diversification

A properly diversified portfolio can help you achieve more consistent returns over time, which may improve the opportunity to attain your ultimate financial goals. Your financial professional can help you determine if there are ways to enhance the level of portfolio diversification in your current investment mix.

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