If you’re an experienced investor, you understand the need to diversify your portfolio. The traditional 60/40 portfolio (60% equities/40% bonds) is a good start. The problem is that many investors believe that holding multiple equities and/or funds means they have a well-diversified portfolio. Others believe that having exposure to a variety of equity sectors is sufficient for diversification. And in the last 18 months, some investors believe that having 50% or more of their portfolio in a variety of cryptocurrencies is diversification.
All of these strategies fall short of the definition of a well-diversified portfolio. In this article, we’re breaking down what it means to diversify your portfolio. We’ll also show you why it can help boost your total return over time.
When You Diversify Your Portfolio, Think Asset Classes
Real diversification includes, among other things, owning a variety of asset classes. In addition to stocks and bonds, diversification means investing in other asset classes like commodities (for example, oil and precious metals), real estate and even cryptocurrencies.
But that’s just the beginning. Within each asset class, investors should strive for diversification. For example, if you have money in a handful of exchange-traded funds, but each ETF carries many of the same equities, that’s not diversification.
A better approach is to buy shares of ETFs that have complementary (not necessarily correlating) holdings. For example, investors can buy an ETF that focuses on technology stocks to gain exposure to growth stocks. But they can also buy an ETF that carries a basket of blue-chip stocks that pay a consistent dividend.
The Role of Risk Tolerance in a Diverse Portfolio
The good news is that it has never been easier for you to diversify your portfolio. The proliferation of zero-commission trading and the ability to buy fractional shares makes it easy for investors to get small exposure to multiple asset classes.
For example, to invest in real estate, investors can choose to buy shares in a real estate investment trust (REIT). If they want to buy commodities there are a number of mining stocks and ETFs that will provide that exposure.
However, a truly diversified portfolio must account for an investor’s risk tolerance as well as their timeline for reaching their investment goals. Both of those factors will impact how much or if they should have exposure to a specific asset class.
The Goal Is Still a Better Total Return
The benefit of a well-diversified portfolio is a matter of having asset classes that complement each other. Put a different way, when you diversify your portfolio, you optimize your total return, while managing your risk.
At any given time, one asset class will outperform another asset class. However, market timing is an imperfect science even for the most seasoned investors. That’s why having exposure to multiple asset classes gives an investor peace of mind that when some of your investments are down, others will be up.
During a bull market, your portfolio may not give you bragging rights at a dinner party. But having a diversified portfolio should mean you’re outperforming the market. Rather, you’ll do better than others when the market is in a downturn.
On the date of publication, Chris Markoch did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.