Why Portfolio Diversification is Essential for Investors Today

The saying “don’t pull all your eggs in one basket”, though time-worn and overused, is never not relevant. Within the investment space, it is used to rationalize the need for portfolio diversification. The rationale here is relatively simple: It’s advisable to have strategic exposure to different asset classes, industries, and geographies to mitigate the risks and maximize the returns. Typically, the proponents of portfolio diversification deploy certain investments into mutual funds, ETF stocks, bonds, real estate, and alternative investments such as crypto. In recent years, such strategies have enabled investors to navigate market volatilities and safeguard themselves from a financial fallout due to an unforeseen nosedive in an individual segment.

If portfolio diversification is not a novel practice, then why is it being emphasized at this moment in time? The answer lies in the unprecedented nature of these times. The pandemic — the first of its kind in the globalized world — adversely impacted the financial markets, undoing years of accrued progress, capitalization, and revenue growth. The concomitant supply-chain shocks have continued to induce inflation. Geopolitical issues are hampering the supply recovery. So, investors should diversify their portfolios by factoring in all conditions and eventualities. 

For example, supply issues have increased material costs, leading to retail inflation and reducing brands’ valuations and share prices. At the same time, commodities such as oil have witnessed considerable appreciation, giving investors a windfall. So, an effective diversification strategy at the post-pandemic outset was to rebalance the portfolio by increasing exposure to commodities such as oil and Precious metals. Similarly, there are multiple considerations behind portfolio diversification at any given time. 

Risk mitigation: There is a consensus that investments with long “time horizons” are less risky, owing to the available time for market corrections. However, low-risk asset classes do not often generate massive returns. Alternative investments such as cryptocurrencies offered investors a windfall until their market capitalization plummeted. So, effective portfolio diversification boils down to timing. Hence, rebalancing at least once a year or, ideally, once every six months is advisable. 

Liquidity: Conventional assets such as Treasury bonds, mutual funds, ETFs, and stocks offer greater liquidity but accompany certain market risks. So, if liquidity is the objective, they are promising avenues to consider. Commodities take considerable time to gain value, making associated investments less profitable for liquidation. The same can be said about mutual funds—they can be easily liquidated but with implications for returns. Investments in real estate are less viable as these assets are illiquid, accompanying challenges in transactions. 

Alternative investments are instruments other than conventional categories, such as stocks, bonds, and mutual funds. They often accompany flexible investment options but entail long-term commitment. For example, hedge funds, a limited partnership of private investors managed by managers who deploy them strategically to maximize returns, can be considered part of diversification. Even alternative options such as private equities and debt investing offer unique advantages to mitigate risks and rake in good returns, but they sometimes require long-term participation. 

Portfolio diversification strategies

Since portfolio diversification became a discipline, it has had three major categories: in-asset diversification, geographical diversification, and asset-wide diversification. While the fundamentals governing all three categories have remained the same, the strategies have evolved in response to changing investor sentiment, geopolitics, technology absorption, and market dynamics. 

• Individual asset diversification: As the name suggests, this strategy revolves around investing in different assets within the same class. Investors prefer this with a strong propensity towards and expertise in certain asset classes. At times, this approach is rooted in years of experience. For example, in investments in the S&P 500 Index, which combines the performance of 500 stocks in the index, index providers are responsible for ensuring the composition of an index adequately reflects its stated methodology. Investors tend to rigorously follow companies’ financials and value propositions before allocating. Likewise, investors can invest in other stocks across industries and geographies. 
• Geographical diversification: Portfolio diversification has assumed a solid geographical focus due to recent developments such as the Russia-Ukraine conflict. This approach is asset class-agnostic but involves strategic exposure to different economies. Proponents tend to buy into certain asset classes in countries with good growth prospects for the same. As often as not, this involves analyzing supply chains, local economic conditions, public governance, monetary policies, and exit options. This approach is prevalent among investors who are wary of the geopolitical situation in their home countries. With geopolitics increasingly impacting local financial markets, portfolio diversification across geographies is set to rise for the foreseeable future.
• Asset class diversification: This is perhaps the most common form of portfolio diversification, wherein allocation is across asset classes such as equities, bonds, and mutual funds, among others. During rebalancing — paramount in asset class diversification — investors tend to increase or reduce exposure to certain assets as per recent performances and future predictions. At times, the allocation is also across industries such as crude oil, agriculture, and technology. The bottom line is to be invested in low-risk and high-reward asset classes. 

Previously, portfolio diversification accompanied rigid rules such as 60:40, wherein equities and fixed-income assets had 60% and 40% weightage, respectively. Such inflexible approaches are viable in steady economic cycles without inflationary and recessionary pressures. However, at the moment — and for the foreseeable future — portfolio diversification requires fluid strategies in light of the ever-dynamic fiscal policy environment, interest rate changes, and geopolitical uncertainties. 

Regardless of the fluidity of your strategies, portfolio diversification can still run into risks. In volatile economic cycles, non-diversification is better than haphazard and hasty diversification, where you can make wrong investments. Financial markets are increasingly defying patterns, so past performances are unreliable determinants of future success. A financial advisor can be beneficial when it comes to portfolio diversification and periodic rebalancing. Finding the right financial advisor that fits your needs doesn’t have to be complicated. 

If you are ready to be matched with an advisor who can help you achieve your financial goals, write to us at info@cfsgroup.com. Get started now.