How to Diversify Your Investments and Protect Downside Risk

What Is Diversification?

When considering risk management in your portfolio it is important to recognize that a diversification strategy will serve as the heartbeat of a well-constructed portfolio and long-term financial plan.

A simple definition is that diversifying is the process of spreading your financial resources across many different investments and asset classes to help reduce risk of loss and potentially increase investment returns. This strategy can consist of buying stocks in different global regions and markets, investing in different asset classes, creating different types of income streams, and using different types of accounts to gain exposure to different tax impacts. The key to any long-term portfolio success is to use diversification to optimize the returns you receive for the amount of risk you take.

Benefits Of Diversification

Two of the biggest benefits of diversification are reducing risk in your portfolio and potentially increasing returns over the long run. These are the most common understandings of a good risk management strategy but, while this sentiment is correct, it is too basic when considering how to grow your total net worth and ignores the fact that you can “over-diversify” and make things worse. Some other large benefits of diversifying correctly are that you will have more buying opportunities, increased peace of mind and, most importantly, it helps automate the process of “buying low and selling high” to extend how long a portfolio will last during retirement.

At a basic level, having investments across many different asset classes will help reduce risk in a portfolio since not all investments will increase or decrease in value at the same time. The most basic example of this is that often stocks and bonds will be performing in different opposite directions in any given year, and rarely do they both decrease in the same year. However, there are times when they will go in the same direction, such as in 2022 when they both declined, which serves as an excellent example of why other asset classes such as multifamily apartment real estate, inflation hedges or reinsurance can be good additions to an investor’s plan for success. The addition of multiple, uncorrelated asset classes allows investors to have something in their portfolio that is performing well, or at least not as poorly, and this enables them to continue to rebalance and implement the process of buying low and selling high.

While spreading your money around in different places may help reduce risks in your portfolio, it does not necessarily mean you will increase the return of your portfolio. The strategy does, however, lend itself to the rebalancing process that will help provide investor options in both good times and bad. As discussed more below, when done on a regular basis over an extended period of time, rebalancing has been shown to potentially increase returns of market based investments.

The other important benefit of diversifying is rarely discussed by most investors due to a lack of understanding and clarity. This type of benefit will never be transparent in terms of a percentage gain or loss, it will not show up on an account statement, and requires serious overwatch to ensure this diversification strategy is working efficiently. If you guessed it is reducing the tax impacts of investments then you are ahead of the crowd. As an example, an investor in the top tax bracket may be exposed to over 40% total tax between State and Federal taxes combined. If they invest in assets that produce dividends, interest or other income, all this “return” may be taxed at ordinary income rates in the highest bracket. So for an investment that may pay 10% each year, an investor has accidentally reduced the after-tax return to 6% (or less) just by not owning the investment in the correct type of account. However, proper diversification of asset location will provide the benefit to sophisticated investors of preserving their return so their net worth grows even faster.

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Diversification Strategies

The best diversification and risk management strategies take into account that an investor needs to have buying opportunities when markets may be in turmoil, facing inflation or one of their investments goes poorly. To accomplish this well, one must have an investment allocation they are targeting over the long term that covers multiple asset classes, global markets and market sectors. Often, this strategy is related to trying to own the global markets in the same ratio as they exist, to gain exposure to all the movements of the world investment markets. Simply put, if you own everything you should own things that are showing different returns in any given year, and this will allow you to capitalize on the process to buy low, sell high, rebalance the portfolio to reduce risk, and take advantage of movements in the market to potentially increase returns.

Another diversification strategy for investors to consider is adjusting their portfolio based on sector rotation. This strategy involves moving your money from one industry to another–perhaps buying investments that may perform well given the current state of the economy, government initiatives or pop culture trends–in anticipation of the next economic cycle. Recent examples of this include owning multifamily real estate complexes, technology and healthcare. It is important to note that when it comes to strategies like sector rotation investors are trying to time the market, which, of course, for a majority of retail investors leads them to underperform the market returns of a quality risk-adjusted portfolio and create higher taxes for themselves. So if your approach is long term, hands off or passive, sector rotation is likely not a strategy you should try to implement.