Although investment risk increases and decreases over time based on a number of factors, it never disappears. One way to potentially protect your portfolio? Improve your diversification strategies.
Understand sources of risk
Before you look to adjust diversification in your portfolio, consider these common sources of uncertainty and volatility:
- Interest rates. Changes in the interest rate may affect your portfolio differently. For example, if interest rates are lowered by the Federal Reserve: bond prices may rise; stock prices may rise; savings accounts and CDs will have lower rates, commodity prices rise, and mortgage rates fall. “Changes in the interest rate shifts the prices for fixed income investments, either improving or diminishing investor total returns,” says Rob Haworth, senior investment strategist for U.S. Bank.
- Corporate earnings. Gains or losses in company earnings often translate directly into stock price changes. “Improving corporate earnings tend to support stock prices, while declines often pressure prices,” Haworth says.
- Policy. Government policies on matters such as spending, trade and international relations can create an uncertain environment for investors. Monetary policy decisions by global central banks can also introduce uncertainty to key factors for investments. “These policies often change the pace, trend or magnitude of economic and investment fundamentals,” says Haworth.
Mitigate risks with diversification
Diversification is important in investing because it can help mitigate the risks that uncertainty creates. But many investors believe that their portfolios are more diversified than they actually are. For example, investors may have both stocks and bonds, which gives them diversity in asset classes. However, if an investor’s stocks are concentrated in a small number of industries, risk increases.
Haworth recommends these diversification strategies, if appropriate for your situation, to potentially mitigate the risks to your investments:
- Own assets in different industries. “Let’s say you happen to own a lot of a technology company,” he says. “You really need a diversified exposure around that.” Why? Because the technology industry behaves differently than other industries — such as energy, healthcare, financial services or consumer staples — under different economic conditions. If the economy slows, technology and luxury stocks tend to decline; meanwhile, consumer staples stocks tend to hold steady because of consistent demand. If the economy expands, the financial services industry often benefits.
True diversity comes from owning assets that have the potential to provide different payoffs under different economic conditions.
- Invest in foreign markets. U.S. markets comprise about half of the global stock market in terms of value, so international markets offer another way to diversify the stock portion of a portfolio.
Just as the returns of one industry typically differ from those of other industries depending on the state of the economy, global markets’ returns often differ from those of the U.S., Haworth explains. In addition, the top company in some global industries is based outside the U.S., which means investors who own only American companies could be missing opportunities for both diversification and growth.
- Diversify stock and bond allocations. Some investors own a substantial amount of stock in a single company. This often occurs if they’ve worked for a company for a long time and the company offers an employee stock purchase plan or stock options. Sometimes, members of a family own a large number of shares in a single company due to familiarity.
It’s important to have diversity in not just the stock portion of a portfolio but also the bond allocation. According to Haworth, high-yielding, low-quality bonds often behave like stocks and therefore don’t effectively balance the risks associated with equity ownership. Investors should consider holding a sufficient share of their bond portfolio in high-quality bonds in order to achieve true diversity and balance risk and return.
Diversification in investing can help mitigate the risks that uncertainty creates. But many investors believe their portfolios are more diversified than they actually are.
A financial professional can help provide necessary perspective and insight into how volatility may impact your portfolio over time and what diversification strategies make most sense for you.
Concerned about a market pullback?
Consider these 4 ways to manage downside risk.