Q: I always hear that diversification in my investment portfolio is important, but how can I tell if mine is well-diversified?
A: Diversification is certainly important, and it’s not always easy to tell how your portfolio is doing in this regard. There are a lot of factors to consider, and we’ll briefly discuss a few of them here.
The allocation of stocks versus bonds is arguably the most important layer of diversification. While these aren’t the only two asset classes, they’re likely the most used. The critical thing to consider here is that each asset class behaves differently. Generally, stocks are riskier than bonds. However, this doesn’t mean one is inherently better than the other, as each plays a vital role in an investment portfolio. At Rodgers & Associates, we view stocks as a tool to help a portfolio grow over time and keep pace with inflation, whereas bonds may serve to reduce overall volatility and preserve principal.
Once the stock allocation of your portfolio has been decided, you’ll want to consider how exactly you’re going to invest it. When investing in U.S. companies, many investors diversify based on Market Capitalization, which is essentially a measure of the size of a company. Stock of large, medium, and small companies may all behave differently, and investing in some of each adds an important layer of diversification. Investing in international companies may also help balance your stock holdings.
When picking stocks, it’s wise to consider what a company does in addition to its size and location. Knowing the economic sector is a general way to determine this. There are 11 of these stock market sectors: Materials, Utilities, Industrials, Healthcare, Financials, Energy, Consumer Staples, Consumer Discretionary, Information Technology, Real Estate, and Communication Services.
Consider these two scenarios:
- Portfolio A consists of 100 individual stocks that are all invested in healthcare companies
- Portfolio B consists of 50 individual stocks that are spread across all 11 sectors
Which is more diversified? While 100 stocks might sound better than 50, portfolio A is much more reliant on the performance of the healthcare sector. If the sector does well, so does Portfolio A. If the sector performs poorly, Portfolio A would hypothetically be much more impacted than Portfolio B. Keep in mind that “sector” in this context describes a large swath of the economy, so this is far from the only way to determine if your portfolio is diversified.
Number of Stocks
Is there a magic number of stocks that makes a portfolio diversified? Unfortunately, not. This is largely because, as the above example shows, other factors are more influential than just the number of stocks at play. With that, if diversification is your goal, you may want to look beyond individual stocks. Exchange-traded funds (ETFs) and/or mutual funds can provide relatively easy and cost-effective diversification depending on the investment strategy of the fund.
While this might seem complex, what we’ve covered here barely scratches the surface! At its core, diversification is meant to manage (not eliminate) the overall risk of an investment portfolio. Our advisers recommend using mutual funds and ETFs spread across several different categories to fulfill the stock allocation of a portfolio and short-term bonds to fulfill the bond allocation. If you want reassurance that your portfolio is balanced, we’d be happy to meet with you to make sure you’re taking the right amount of risk.