Types of Portfolio Diversification
As an investor, you know how important it is to keep your retirement portfolio growing—be that through investing more money or by keeping up with your returns. Even the savviest investors may not be aware of the full range of investment diversification options that can take their portfolio to the next level. Whether you’re a self-driven investor who monitors your own portfolio or you have the assistance of a financial advisor, there are still diversification opportunities that you might not be aware of—especially in the alternative investment space.
There are a host of different types of portfolio diversification: some are better than others depending on your overall asset mix, goals, and the timeframe in which you’re investing. We’ll walk through some of the best strategies for portfolio diversification, be they through the conventional stock market or by way of alternative investments. We'll also cover some of the best products for diversification for protecting assets, providing yield, or unlocking access to different market sectors.
Why it’s important diversify the right way
Before we dive in and go over the best types of portfolio diversification, it’s important to understand the ideal way to approach portfolio diversification in the first place. Although most investors know how vital it is to diversify their assets, fewer know that there are plenty of pitfalls involved in doing so the wrong way.
Over-diversification is a very real phenomenon, even if it’s not a term that might be on your radar as an investor. This occurs when your portfolio’s underlying assets go beyond the point at which marginal losses are greater than the hedge against risk that diversification is supposed to provide. In other words, when you over diversify, you’re spreading your money around so much that you’ve nullified your protection against losses—and have even exposed yourself to the potential that losses across your various holdings could put you at a disadvantage.
Investors that over-diversify may also own too many overlapping investments, such as multiple funds in a single sector or economic region. In most cases, owning shares in funds with similar strategies means having shares in the same companies—albeit through two or more funds. This redundancy causes you to pay fees twice on the same underlying assets, which can eat away at your overall gains.
One other common pitfall is buying into different investments purely out of a desire to diversify. You’re better off investing more into a smaller handful of well-researched stocks than spreading investments across a wider (and less familiar) set of opportunities. Some experts suggest that 50 stocks is the golden number for most investors, although that’s somewhat flexible.
With these common mistakes in mind, it becomes all the more critical for investors to seek out the right diversification strategies. Thankfully there are several approaches; each of which can provide unique benefits.
Asset class diversification
Every investor knows it’s vital to spread money across a mix of stocks, bonds, and other investments. This is known as asset class diversification, and is the backbone of a well-balanced and diversified portfolio. As a refresher, asset class diversification can help right-size your exposure to different parts of the market. If you were to invest exclusively in stocks, you’d run the risk that a market downturn could wipe out your assets. Alternatively, if you only invested in bonds or funds, you’d run the risk of losing out on more significant gains that you’d get with other holdings.
The actual division of asset class allocation is up to you. In the past, many experts recommended the “60-40 rule,” which suggests that 60 percent of your portfolio should go to stocks and the rest to bonds. The general idea behind this is that bonds can serve as a hedge against stock market volatility, but not at the expense of prospective gains.
The sheer volume of investment opportunities now available makes this advice somewhat obsolete. Now, investors should consider incorporating alternative investments in tandem with bonds and other more conservative, yield-bearing assets. Farmland investing can be a great alternative to bonds, given how farmland has enjoyed steady appreciation for more than two decades. Plus, farmland investments pay out a higher yield than treasury bonds on average, making it a stronger value play as an asset class.
It’s essential that investors make sure they have exposure to as many industries as they can. It’s tempting to throw the bulk of your assets into whatever the hot sector of the day is, but this approach can be more aggressive than your average long-term investor can (or should) stomach. Not only do you risk losing big if your portfolio is overexposed to a specific industry, you also risk losing the opportunity to make gains in other sectors you might have overlooked.
Many investors tend to over-invest in sectors that dominate their regional economy as well. In the Northeast, this manifests as overexposure to the financial sector. In the heartland, industrials have the same effect. Investors in energy-producing states tend to—you guessed it—overdo it on energy-related stocks holdings.
One simple way to avoid this phenomenon is by seeking out opportunities to leave the research and heavy lifting to the experts. For example, farmland investing can be a great opportunity for every investor, even if you may not know much about the industry. Instead of going it alone, working with a company like FarmTogether can take care of due diligence and opportunity identification, allowing you to diversify in a market that you may not be familiar with.
Ideally speaking, you should have a stake in as many industries as possible, excluding those that are in trouble for the short- or long-term. Depending on your appetite for risk, you could always put a greater emphasis on certain sectors where you see opportunities. By and large, however, a good and balanced mix of industries is advisable for most investors’ portfolios.
Time diversification is one of the most overlooked ways to spread out your portfolio. A good mix of short-term and long-term holdings is essential for capturing quick gains and turning them into long-term interest generators. If you’re able to capture short-term earnings, you can reinvest that capital into long-term plays. This, in turn, helps you grow your overall portfolio through compounding interest—essentially building up your baseline for long-term growth.
You may have heard of time diversification with regard to dollar-cost averaging. Dollar-cost averaging helps you avoid common investing pitfalls, such as unlucky timing with the markets or not making consistent contributions to your portfolio. Essentially, when you balance short- and long-term investments, and make sure that you’re adding money consistently, you can take a more hands-off approach to how you grow your capital.
One surefire way to include time diversification is through investments with a target hold period. This is the point at which the investment is expected to provide liquidity to shareholders, either from the sale of the investment. Farmland investing, for example, usually has a target hold period of anywhere from 6 to 10 years.
Bonds are another common time diversification option. Bond durations vary significantly, but can avail you to a set return at the end of their cycle. You can ladder bonds so that they mature at different times, therefore keeping a steady return coming your way. The same can be said for certificates of deposit, or CDs. Current interest rates may make both bonds and CDs less attractive than farmland, however, as interest rates for bonds and CDs are near zero.
Why alternatives belong in your diversified portfolio
The best way to make sure your portfolio is diverse enough is to look beyond the markets for investment opportunities. The world of alternative investing has never been as accessible (or attractive) as it is now. Accredited investors can take advantage of fractional ownership opportunities in sectors that were once too complex or expensive to be a consideration for most.
FarmTogether is a perfect example of how you can add alternatives into your diversification strategy. Farmland offers the steady returns of other alternative investments like gold, the yield-bearing potential of bonds, and the industry diversification opportunity that makes for a well-rounded portfolio. Getting started with FarmTogether is easy, too: you only need $15,000 to get started with one of our investment experts. From there you can choose from an array of farmland opportunities across the country.
Disclaimer: FarmTogether is not a registered broker-dealer, investment adviser or investment manager. FarmTogether does not provide tax, legal or investment advice. This material has been prepared for informational and educational purposes only. You should consult your own tax, legal and investment advisors before engaging in any transaction.