An investment portfolio is only as strong as its ability to perform well in turbulent – or even down – markets. Diversification can make the difference between riding an unpredictable roller coaster and sailing steadily on a stable ship capable of weathering storms. In short, a diversification strategy aims to help investors take the least amount of risk needed in order to earn their target return in the most stable and predictable way possible.
Understanding how to diversify your portfolio properly starts with understanding the fundamentals of diversification, and asking the right questions to figure out how to apply these principles to your personal portfolio in practical ways. In this article, we look at crucial questions that you should ask in order to evaluate the effectiveness of the diversification of your own investment portfolio, whether you’re just getting started or have an established investment strategy. With answers to these questions, you will be better prepared to make informed investment choices and build a stronger portfolio capable of earning more stable, potentially higher returns while also taking less risk.
1. What is my risk tolerance?
Risk reduction is at the heart of diversification, and it’s used specifically to reduce unsystematic risk, also known as diversifiable risk. While exposure to unsystematic risk, or volatility, can be reduced by using a strong diversification strategy, it’s impossible to eliminate risk from any investment altogether. Therefore, before choosing investments to diversify your portfolio, it’s important to determine the amount of volatility that you’re comfortable taking on – or your risk tolerance.
Some investments come with higher return potential than others, but higher return potential usually also comes with a higher risk of partial or even total loss. In general, the higher the risk, the higher the return potential should be. If you have a low risk tolerance, you may want to limit yourself to investments with lower return potential as a trade-off for lower risk exposure. If you have a moderate or aggressive risk tolerance, you have a wider selection of investment options, which may come with higher return potential, but also a greater risk of loss.
Risk tolerance usually changes with age and investor goals, but there’s no standardized path for risk tolerance. Risk tolerance isn’t only determined by age and net worth, but also by personal preferences.
A well-diversified investment portfolio usually doesn’t comprise investments of one risk level. Instead, a well-diversified portfolio usually contains investments of various levels of risk. But when viewed in its totality, an investment portfolio’s risk level should be in line with your personal risk tolerance – and maximize return potential at that given level of risk.
2. What is my risk-adjusted rate of return?
Your goal as an investor is likely to maximize returns at your given level of risk. To do that, it’s important to understand how much risk you’re taking on, and the return potential that you’re receiving in exchange for taking on that risk.
In other words: How well are you being compensated for the risk that you’re taking on?
Using the efficient frontier first introduced under the Modern Portfolio Theory (and subsequently by other investment strategies, which have tweaked it), an investor can map out the maximum return potential available to them at any level of portfolio risk. This can help you determine how well your investment portfolio is positioned to perform when the risk of loss is taken into account. The further your portfolio falls below the efficient frontier, the less compensation you’re receiving for the risk you’re taking on – which makes that risk unnecessary from a financial standpoint.
If your portfolio falls along the efficient frontier, then you’re likely in the best position possible to earn the greatest return at your given level of risk. Finding an investment allocation that falls right along the efficient frontier curve can be difficult. But before you can find the right allocation, you first must determine the level of risk tolerance that’s right for you.
Once you assess your risk tolerance and understand how your investment portfolio allocation is positioned to perform, you can then start examining your current portfolio allocation and investment options.
3. How many asset classes am I invested in?
It’s likely that you’re invested in more than one asset class, but do you know how many asset classes you’re invested in? Is your portfolio composed mostly or entirely of stocks and bonds, or have you branched out to other major asset classes? Most investors invest at least part of their portfolio in equity through stocks, and in fixed-income assets through bonds. But there are many investment options beyond those two asset classes.
Investments have different traits at the company level, industry level, sector level, country level, and beyond, but the fundamental structure of assets is divisible at the asset class level. At the asset class level, investments can have different return structures and investment horizons, among other traits. By investing in securities across multiple asset classes, investors can reduce correlation within their portfolios – and ultimately volatility – in one of the most significant ways available. Obviously, the lower the volatility of a portfolio, the more stable it is.
In addition to the equity and fixed income assets available in the public market, there are also money market instruments, also known as cash equivalents, commodities, currency, and real estate. Money market instruments include treasury bills, certificates of deposit, and short-term government bonds, among other assets. Commodities include raw materials, such as gold, natural gas, and more. Currency includes cash, foreign currencies, and increasingly digital currencies or cryptocurrencies. Real estate is typically traded through real estate investment trusts (REITs) in the public market.
Many of these same asset classes are available in the private market, but the investments available within each asset class can be different – and they face very different market dynamics. That’s why private market investments can offer immense diversification potential for portfolios heavily invested in public market investments. In general, the public market has experienced greater correlation and volatility due to its shrinking size and increased concentration of ownership, as discussed below. This makes diversification across private alternative assets increasingly important.
4. What value does each asset class add to my portfolio?
The greatest diversification and risk reduction value is found in investing across asset classes with little or no correlation. Why? The performance of these investments share little to no relation to one another – positively or negatively. The less that prices of different investments move in unison, the more stable the returns of an overall portfolio are expected to be.
For example, if there’s a spike in oil prices, both an airline company and a car rental company share a risk of loss due to the fact that the profit potential of both companies depends on oil prices. Even though the market risks of an airline company and a car rental company aren’t the same, they are related, because they both rely upon some of the same inputs, including oil. If you own investments in both companies, both of those investments share a risk of being negatively affected in this scenario.
However, if you invest in asset classes with low or no correlation to one another, then your portfolio’s risk of loss could be mitigated significantly. If you invest in a publicly traded airline company, and an uncorrelated asset class, such as private market real estate, your investments likely wouldn’t share many – if any – of the same risks. Therefore, if your airline investment performed poorly due to a rise in oil prices, the performance of your real estate could stem those losses, which means that this portfolio diversification is stronger.
In general, publicly traded investments are considered traditional investments, and private market investments are considered alternatives. An investment portfolio that contains exposure to alternatives, which are known for their low correlation to public market investments, has much more meaningful – and therefore powerful – diversification than an investment portfolio invested only in traditional, publicly-traded investments.
5. Am I diversified within each asset class that I’m invested in?
Investing in a diversified mixture of uncorrelated asset classes will enhance your portfolio diversification, but that diversification power is lowered – or lost – if investments are concentrated within each asset class. If you invest in only five different stocks and three different bonds, you have a high concentration of investments within each of those asset classes. If one of those investments experiences a loss, then your investment portfolio will likely be hit hard. But, if you invest in dozens or hundreds of investments within each asset class – with as little correlation between investments as possible – then you would have far more diversification both at the asset class level and the individual investment level.
Index funds (a type of mutual fund), and exchange-traded funds (ETFs) have grown in use in recent years due to the broad exposure that they offer investors in the public market. Index funds and ETFs can be invested according to a particular index of stocks, bonds, commodities, industries, sectors, country, and more, giving investors a way to diversify along a variety of different parameters.
In the private market, this level of diversification within an asset class is more difficult to find due to the fact that private markets generally have higher barriers to entry and less options for investors. Nonetheless, it’s becoming increasingly possible for anyone to diversify among various private alternatives. Alternative assets have been historically – and largely still are – more readily available to high net worth investors who can access investment vehicles such as private equity funds or private REITs.
However, the introduction of technology-driven online real estate investment platforms, such as Fundrise, following the JOBS Act brought new options to investors of all stripes by offering access to portfolios of private market real estate diversified across dozens of investments by debt and equity investments, commercial and residential real estate, as well as geography. This provides investors with not only exposure to an alternative asset class, but also critical diversification within this asset class.
With this model, performance does not hinge upon the success – or loss – of a single property. Instead, exposure to dozens of diverse assets with distinctive sets of risks based on property type, geography, investment structure, and more, gives investors an opportunity to reduce the overall risk of a portfolio and achieve robust diversification among their alternative investment holdings.
6. How many markets am I invested in?
As you may have already learned from the above questions, the market in which an investment is traded impacts its diversification power. Markets can be categorized across many lines. They can be broken down by function such as capital markets, money markets, and derivative markets, among others. They can also be classified by new issue (first market) and the re-selling (second market) of investments, including primary, secondary, tertiary, and quaternary markets.
While these categorizations are important, the most fundamental form of market differentiation – and likely the most crucial to your portfolio’s diversification – is the distinction between public and private markets.
Many seemingly similar investments can be bought and sold in both the public and private markets. But the differences in buying and selling dynamics between these markets make investments that seem the same in most aspects very different in reality. These differences are important, because they have the power to make public market investments and private market investments complementary for the purpose of diversification.
Investments traded in the public market share many traits, and these shared traits translate into correlation. Public markets are highly efficient, offering access to high levels of liquidity. Investments in this market can offer investors the ability to buy and sell investments quickly at any time, but the homogeneity in public market dynamics also creates correlation – and therefore volatility – among publicly traded investment vehicles.
On top of intermarket dynamics, the shrinking public market, concentration of ownership of available investments, and the increased indexation of public investments have contributed to the reduction in the number of investments available to public investors as well as increased correlation among those investments. Due to these factors, investing solely in public market investments has limited diversification potential for investors.
The private market, in comparison, is far more inefficient with higher transactional friction. It’s also more fragmented rather than centralized with asymmetric information available to buyers and sellers. While the dynamics of the private market may seem undesirable for investors on the surface, its inefficiency actually offers a way for investors to “beat the market” – or earn alpha, because prices are not set by the market, but negotiated between buyers and sellers. In other words, investors who are well-informed or skillful may have an opportunity to earn above-market-rate returns.
These disparate conditions ensure that the performance of an investment in one market doesn’t rise or fall in tandem with the performance of an investment in another market. For instance, if the value of a publicly traded REIT falls, it will likely have little or no impact on the value of a property held by a private equity fund, or a non-traded REIT, because of the differences in market dynamics. While opinions of public investors may impact public REIT share prices, non-traded real estate asset values are based more so upon property-level fundamentals like net operating income and density allowances.
The lack of correlation between public and private assets at the market level make investments in each market complementary portfolio diversifiers. Therefore, the volatility and overall loss potential of an investment portfolio composed mostly of publicly traded investments can be significantly reduced by adding alternative investments found in the private market.
7. How will my portfolio be impacted by inflation?
Unfortunately, earning an investment return doesn’t necessarily mean you’re getting ahead financially. That’s because, generally speaking, currency loses value each year due to inflation. This is why a dollar in 2019 doesn’t hold the same purchasing power as it did in 1919. Therefore, it’s important to ensure that your portfolio’s risk-adjusted earning power is maximized, so the growth of your wealth not only keeps pace with inflation, but surpasses it.
For example, if you earn a 5% annual return in a year when inflation rises 2%, your wealth could be growing at a slower pace than you may realize. Or, even worse, if your investment portfolio has a loss in a year when inflation rises 2%, your losses are automatically even worse.
Earning high returns can help hedge rises in inflation, but some assets are more suited than others to outpace inflation. In particular, hard assets are most capable of hedging inflation, because they hold intrinsic value due to the fact that they’re naturally limited in supply. This intrinsic value gives a hard asset its ability to keep pace with – or exceed increases in inflation.
Some examples of hard assets include gold, diamonds, oil, and commercial real estate. Commercial real estate is unique, because unlike other hard assets, its value can not only rise – or appreciate – with increases in inflation, it can also earn income in the form of rental payments while it appreciates. For these reasons, real estate has historically offered a strong diversification option for those seeking to build a strong portfolio capable of weathering periods of inflation.
8. Am I following a defined diversification strategy or am I just “diversifying”?
Far too often, investors make the mistake of believing that their portfolios are sufficiently diversified, because they own a variety of investments. But as you may have learned already, ownership of dozens or even hundreds of different investments doesn’t necessarily guarantee meaningful diversification. A strong diversification strategy must take correlation into account. Choosing investments with low or no correlation at several levels, as discussed, can reduce total portfolio correlation, and therefore risk of loss. That’s because – mathematically speaking – by diversifying into investments with low or no correlation, you can lower your overall portfolio volatility.
A risk-adjusted return profile that falls along the efficient frontier, as discussed above, usually demonstrates the strength of your diversification strategy. If your strategy isn’t maximizing your risk-adjusted return potential, then your portfolio allocation isn’t as strong as it could be, which leaves you exposed to risk unnecessarily. If you’re not sure how strong your portfolio allocation is, a mean-variance analysis can help you determine where your portfolio falls along the efficient frontier curve.
One of the leading diversification strategies that takes into account each element that we’ve discussed in this article is the 20% rule. The 20% rule moves beyond focusing exclusively on the public market, and emphasizes investing 20% of your investment portfolio in alternatives in the private market for the purpose of bolstering your portfolio’s diversification and earning power. First created by the Chief Investment Officer of the Yale Endowment, David Swensen, more than a decade ago, the diversification strategy has grown in prominence, and others, such as Blackstone, Blackrock and Baird now demonstrate how a 20% allocation to alternatives can improve a portfolio’s diversification and position along the efficient frontier.
What’s the Next Step for Your Diversification?
As an investor, you’re likely trying to maximize the return potential of your portfolio. But along with returns, risk needs to be monitored as well. It’s important to ensure that you’re taking on no more risk than is necessary to earn the level of return that you’re aiming for.
These questions can help you take a fresh examination of your investment portfolio and assess the strengths and weaknesses of your asset allocation as well as the effectiveness of your diversification.
If you’re like most individual investors, who are lacking critical exposure to alternative investments in the private market – and the diversification that comes with them – there are now more investment options than there were less than a decade ago for investors of all stripes. Thanks to advancements in regulations and technology, some private market investments are more accessible for investors of all sizes than they have ever been.
Fundrise offers an innovative, hands-off way for anyone to diversify into institutional-quality private market real estate with as little as $500. Fundrise not only offers unprecedented access to this asset class, but diversification within in it. With Fundrise, you have access to portfolios of dozens of real estate assets diversified across commercial and residential property types, debt and equity investment structures, and geographically across the US.
We built Fundrise to make diversifying into private market real estate faster and easier. Learn how Fundrise can help you diversify your portfolio today, and how you can get started here.