Diversification is a key strategy for managing risk in an investment portfolio, based on the philosophy that you should not put all your “eggs in one basket.” By spreading investments among asset classes, industries, sectors, geographical areas or other criteria, you are more likely to own securities that perform differently under different market conditions. However, building a diversified and more stable portfolio is not as easy as it might seem.

Managing risk

Diversification increases the odds that at least some of your investments will perform well at any given time. However, simply distributing your money among several mutual funds does not necessarily achieve diversification. Putting your eggs in many baskets will not be effective if the baskets are too similar to each other. This concept is generally known as “false diversification.” To determine whether your portfolio is truly or falsely diversified, you need to drill down beneath the surface.

First, it is important to understand that the goal of investing is not to eliminate risk. After all, without some risk, there would be no rewards. If you invest too conservatively (particularly when you are young), your asset growth may not keep pace with inflation and may erode your wealth over time. However, if you invest too aggressively (particularly when you are approaching retirement), you may expose your wealth to market volatility, which can quickly turn gains into losses.

Diversification, therefore, is a valuable tool for balancing risk and reward. The idea is to spread investments among assets that are negatively correlated — meaning their prices tend to move in different ways in response to the same conditions. If assets in your portfolio are too highly correlated or their prices move in tandem, your portfolio will be more sensitive to market volatility.

For example, if all of your investments are in large-cap stocks, a downturn in the S&P 500 index (which is made up of large-cap stocks) can have a devastating impact on your portfolio. But if your portfolio is properly diversified, poor performance in one area of the market may be offset by gains or more limited losses in other areas.

Right mix

Although the right mix of assets for you depends on your particular circumstances, diversification can be achieved in many ways. These include by:

Asset Class
Stocks, bonds and cash (generally, very short-term debt) tend to behave differently under similar conditions.

Company Size
Large-cap, mid-cap, small-cap and micro-cap stocks often perform differently under similar conditions.

Bond Type
You might invest in a mix of government, corporate and municipal bonds, in bonds of different maturities or durations, or in bonds with different credit ratings.

Investment Style
For instance, a mutual fund or exchange-traded fund (ETF) might focus on growth investing, value investing or a blend of the two styles.

Industry or Sector
The same economic or market factors may affect companies in different industries or sectors, such as technology, energy and pharmaceuticals.

Geography
Diversification can be achieved with a mix of domestic and international investments and, within the international arena, a mix from developed and developing countries. Note that securities from developed countries, particularly of large international companies, often perform similarly to U.S. securities.

These are just some of the factors to consider. The key to successful diversification is to analyze when the movements of your holdings are highly correlated.

False diversification

Mutual funds and ETFs can be great diversification tools. Often, they invest in a specific asset class or follow a particular investment style (although many funds blend several asset classes or styles). But simply investing in several mutual funds or ETFs does not necessarily mean your portfolio is diversified. True, each fund may hold dozens or even hundreds of investments. But if these “baskets” are too similar to one another — for example, if they all invest in large-cap, dividend-paying stocks — their underlying securities will tend to correlate.

To avoid false diversification, ensure your funds provide a mix of assets and investment styles that are negatively correlated. And do not let your portfolio’s strong performance during good times give you a false sense of security. If all of your investments are up at the same time, that can actually be a red flag for false diversification. Tomorrow, they could potentially all decline together. You also could potentially lose money on one or more investments.

Mix it up

In general, the best way to reduce investment risk is to examine your own personal financial goals, time horizon and tolerance for market volatility, and diversify from there. You may not want to do anything that can potentially reduce your portfolio’s upside potential. Remember, diversification also usually lowers downside risk. Talk to your financial advisor about the best way to “mix it up.”

Sidebar: Do you have too much of a good thing?

As critical as portfolio diversification is, it is possible to overdo it. As you add stocks, bonds, funds and other assets to your portfolio, remember the law of diminishing returns. The more investments you add, the less risk reduction you get in return, until it is minimal. At that point, you may actually harm returns.

There are several reasons for this. One is that the more assets you hold, the greater the commissions, fees and other transaction costs you may pay. Another is that investing in a large number of assets makes it more difficult to track and manage your holdings, which can have a negative impact on quality, tax efficiency and asset mix.

For more information, contact Brian Ford at 312.670.7444 or [email protected]. Visit ORBA.com to learn more about our Wealth Management Services.