Getting Diversification Right

One of the first tips any budding investor receives is that diversification is essential. But what about the seasoned, experienced investor? That’s when diversification gets a little more difficult. There’s only so much any investor can do within the markets to fully diversify: introducing more stocks can do more harm than good, and most funds overlap in terms of underlying assets.

If you’ve maximized what the markets can do for your portfolio, it’s time to look beyond conventional investments for alpha. The good news is that there are plenty of diversification opportunities outside of the common slate of stocks, funds, and bonds. Investors just need to know where to look and what to look for.

Asset versus Portfolio Diversification

Although asset diversification and portfolio diversification may sound similar, each are distinct concepts and play their own roles in your investing strategy. Odds are you’re already doing both, whether or not you realize it. Whether you are or aren’t focused on these two concepts, it’s critical that you delineate the two.

What is Asset Diversification?

Asset diversification refers to how you spread your assets across stocks, bonds, funds, and other holdings in your portfolio. This is usually represented as a ratio that spells out how much of your money is in each asset class. Here’s an example:

The first chart shows a basic example of asset allocation, with the second chart providing a further breakdown of how stock holdings could be allocated. You can see through these charts that asset allocation doesn’t get into the specifics of what your individual holdings are. Rather, it demonstrates what percentage of each asset type your portfolio includes.

It’s important to consider asset diversification because this high-level overview demonstrates your risk exposure. Stocks are inherently riskier than bonds, cash, and many commodities. Knowing how these macro factors affect your investing strategy is crucial, especially if you want to better understand your risk exposure.

What is Portfolio Diversification?

On the other hand, portfolio diversification focuses on the individual assets you’ve invested in (e.g. one stock versus another). This is the micro view of your portfolio versus the macro view that asset diversification provides.

Portfolio diversification also focuses on how well your specific investments are performing, and which sectors you’re exposed to by way of your holdings. Here’s an example of what portfolio diversification looks like:

Within this chart are your actual stock holdings, which might look something like this:

As you can see, there’s a major difference between asset and portfolio diversification, as well as how you approach diversification. Diversifying at the asset level means incorporating more than just stocks, bonds, cash, and commodities; you could add alternative investments to the mix, for example.

If you’re only focused on portfolio diversification, you’re seeing half the picture.

What Does A Well-Diversified Portfolio Look Like?

A well-diversified portfolio begins with diversified asset allocations. The more unique asset types you can incorporate into your asset mix, the more diversified your individual portfolio holdings will be.

What’s right for your asset mix may not be right for someone else. This is due to risk tolerance. If your appetite for risk is high (e.g. high-risk, high-reward investing), then a stock-heavy portfolio might be right for you. If you’re somewhat aggressive, but still want to hedge against losses in a volatile stock market, you’ll want to spread your money around a bit more and reduce your stock allocation.

How You Diversify Makes a Difference

Not all diversification options are the same, as we’ve mentioned above. Some are riskier than others as a general asset class, while others may be more stable. Some, such as alternative investments, can include both risk-tolerant and risk-averse holdings.

Low-Correlation Alternative Investments

Investors have incorporated alternatives in their portfolios for years. Gold, real estate, and commodities garner the most attention from individual investors because of their negative correlation with the stock market. For example, see how the price of gold, corn, and farmland fluctuate relative to the S&P 500:

The prices of gold and farmland have, relatively speaking, trended in the opposite direction of the S&P 500 on a yearly basis. That’s because they have a negative correlation to the markets: when the markets dip, these commodities tend to rise in value. That makes them an excellent option for diversification, with farmland being among the best of the bunch in terms of value and growth.

High-Risk, High-Reward Alternative Investments

Not all alternatives are designed to hedge against inflation through steady appreciation. Others, such as cryptocurrency, are far more volatile. This volatility also provides a higher potential for larger gains, but the change of your investment going belly-up is also more likely than the options discussed above.

Ethereum has come close to catching up with the S&P 500 monthly closing price, and Bitcoin’s monthly close price blows the S&P 500 out of the water. But as you can see, the volatility of these two crypto currencies is significant—the S&P has had its monthly peaks and valleys as well, but there have been far fewer sell-offs.

Crypto can be a useful addition to your alternative asset allocation, depending on your risk appetite. This is just one of the more high-risk high-reward alternatives out there, so consider your options carefully before investing.

The Right Way to Diversify

There are several ways to create a well-diversified portfolio. The right one for you depends on a few qualifiers:

• Appetite risk
• Personal investing goals
• Familiarity with different asset types
• Short- and long-term investing strategy
• Gaps in your existing portfolio

That being said, there’s no one-size-fits-all solution. That hasn’t stopped some experts from trying, however. The rise of the 60-40 portfolio took hold in the 1950s, advocating that investors put 60% of their money into the stock market. The other 40% should go to bonds, or so the theory goes.

The 60-40 model is outdated in a world rife with different asset classes. Stocks and bonds are still important of course, but a well-balanced and diversified portfolio should include other asset classes. The more varied your asset types, the more likely you are to capture growth and minimize the hit that comes from turbulence or lost value in any one class (or underlying investment therein).

The best advice in terms of portfolio diversification is that which speaks to your needs. In this regard, it might help to speak to a financial professional who can help you determine how much risk you should take on, what the best hedges against inflation are, and how you can balance your different goals.

Low Risk & High Return Can Go Hand In Hand

You don’t need to go all-in on Bitcoin just to make a respectable yield out of your alternative asset allocation. In fact, the world of alternatives is broad enough to offer low-risk, high-return investments that might be a better fit for the conventional investor’s portfolio.

Aside from alternatives like cryptocurrency and options trading, there are a slew of investment opportunities outside the stock market. Real estate, real assets, and commodities all offer a different investment type than the staid 60-40 rule of investing in the stock market. In fact, if you own your own home, you’re already incorporating an alternative investment into your net worth and finances. Additional investments in real estate or gold also count as alternatives in a well-balanced, diversified portfolio.

You don’t have to stop with these kinds of alternatives, however. Farmland investing provides a low-risk way to diversify your alternative investment portfolio. Farmland has a track record of steady appreciation over time, particularly since the 1990s. Farmland may not make you rich overnight like crypto might, but yields outperform bond interest rates and have the kind of stable returns that help ensure you’re incorporating value investing principles into your financial strategy.

Another benefit to farmland investing in a diversified portfolio is its role as a hedge against inflation. When the price of household goods increases, so too does the value of the land from which they come. Corn and wheat price increases make the land they’re farmed on more valuable, which directly benefits the value of your investment.

Getting Diversification Right

Savvy investors know that diversification isn’t as simple as buying a ton of different stocks and mutual funds. There’s more nuance needed in order to make the most of your diversified portfolio, beginning with a properly diversified asset allocation. When you’re able to diversify the kinds of assets in your portfolio, you can then pursue individual investments within each category that give you the best possible return.