What Is Diversification & Why Is It Important?

April 2022

Diversification is the practice of spreading investments across various asset classes and sectors in order to reduce risk or volatility of a portfolio. Each investor has a specific time horizon and risk tolerance that they are comfortable with and align with their financial goals. Diversification is a tool in order to accomplish those financial goals while reducing risk.

Exposure in one asset class or one sector can be risky over the long term. Due to changes in market cycles and other macroeconomic factors, those sectors or asset classes can be hit hard and reduce prices. If a portfolio has big exposure in that area, it can be detrimental to the value of a portfolio. A solution is to reduce exposure and instead expand into other sectors and classes.

In diversification, it is ideal to invest into uncorrelated stocks. Imagine if Stock A and Stock B are uncorrelated. If there is a supply issue in Stock A’s industry, the share price of Stock A will decrease. This supply shock will most likely not impact Stock B, so Stock B’s price will not necessarily fall just because Stock A fell in value.

This logic also applies to various asset classes, such as stocks and bonds. For example, if interest rates are high, newly issued bonds may be attractive since they are paying a higher interest rate. On the other hand, higher interest rates can hurt growth stocks. Exposure to both can help reduce the portfolio’s volatility if interest rates were to change. The gains from the bonds may help to offset any losses from the stocks.

However, excessive diversification is difficult to manage and expensive. Average investors typically do not have enough capital to own multiple stocks across different industries, own bonds, Treasury bills, and real estate. Because of this, it can help to invest into mutual funds and ETFs. These are baskets of stocks that can help investors gain exposure across various companies, sectors, and asset classes.

What Is Asset Allocation & Why It Matters?

April 2022

Asset allocation is the strategy of determining how much capital to put across various asset classes, such as equities, fixed-income, cash, and alternatives. Asset allocation is based on an investor’s risk tolerance, time horizon, and financial goals. If done properly, asset allocation can help minimize risk and diversify a portfolio.

There is no correct way to allocate various assets across a portfolio. It depends on the investor’s preferences. Regardless, some exposure across various asset classes is better than no exposure. Because of this, investors will ideally allocate some capital to stocks, bonds, and cash.

Some mutual funds offer what is called asset allocation funds. These are diversified portfolios of investments that contain a range of asset classes. These funds can be structured around an investor’s age, risk tolerance, and investment goals.

What are Sectors?

April 2022

A sector is an area of the economy that performs similar business activities. Companies can be within the same sector, such as healthcare or financial services.

Investors can analyze trends and patterns of certain sectors to understand potential price movements or changes in fundamentals for stocks. There are various standards to determine which company is in which sector.

Global Industry Classification Standard (GICS) contains 11 economic sectors: consumer discretionary, consumer staples, energy, materials, industrials, healthcare, financials, information technology, real estate, communication services, and utilities. Standard & Poor’s and Morgan Stanley Capital International are tasked with characterizing companies by sectors and sub-sectors.

Another standard to determine sectors is the Industry Classification Benchmark (ICB) developed by Dow Jones and Financial Times Stock Exchange. The ICB determines a company’s sector based on its major source of income.

There are also different categories of sectors: primary, secondary, tertiary. A primary sector company directly extracts raw materials, such as a precious metal mining company. Secondary sector companies produce the goods that are derived from the primary sector’s output, such as an automobile company. Tertiary sector provides services, such as a restaurant.

Investors are able to expose their portfolios to various sectors by investing in sector-specific ETFs, such as technology or utilities ETFs. Not only does the investor gain exposure to another sector, but they are able to invest in a pool of companies which can help minimize risk and increase diversification.