How To Be Strategic in Diversifying Your Investments

Portfolio diversification is a bedrock principle of investing. It’s a well-established way investors reduce their risk or lessen the impact of losses in an economic downturn.

What is portfolio diversification?

Think of the old saying, “Don’t put all your eggs in one basket.” In other words, make sure you aren’t too heavily invested in any one company, industry or investment type. But, diversifying is more than having a lot of different investments. To be truly effective, it’s important to be strategic in how you choose what’s in your investment portfolio.

The goal is to create a balanced portfolio. You'd do that by investing in a mix of securities with different risk and return characteristics. That way, you’re more likely to compensate for losses or poor performance in one area with gains earned from others.

For example, suppose there’s a sudden downturn in commercial real estate. The impact on your portfolio could be significant if you’ve invested mainly in that sector. But, if you spread out your investment dollars among cash, bonds, real estate, energy, technology and healthcare, you’d likely be less impacted.

The classic 60/40 portfolio is often cited as an example of one used by investors willing to accept moderate risk. It includes 60% in stocks and 40% in lower-risk, lower return investments like bonds. Here’s how a 60/40 portfolio might look in the real world:

60% IN STOCKS >> 30% IN BONDS >> 10% IN CASH EQUIVALENTS

This mix may not appeal to more conservative or more aggressive investors.

Smaller-dollar investors and those who don’t want to spend a lot of time managing their portfolios may use exchange-traded funds (ETFs), mutual funds or index funds as a way to automatically diversify their holdings. These funds allow investors to invest in many companies with 1 purchase. And, they're researched, tracked and managed by the funds’ investment managers.

Obviously, there are no one-size-fits-all templates. Some researchers have begun recommending a broader allocation of assets to achieve long-term growth. But, for many investors, protecting against losses is what is most important to them. You’ll want to customize your portfolio depending on market conditions, your specific circumstances and how much risk you’re willing to take. Plus, as things change, your strategy probably should as well. It can help to get advice from a knowledgeable professional.

Why is diversification important in an investment portfolio?

Clearly, a major benefit of a well-diversified portfolio is reducing your risk. But, that’s not all.

• Since you’re not depending on the performance of a limited number of investment types, you’ll potentially have greater opportunities to increase your earnings.
• You can watch current market trends and take advantage of growth industries.
• You can take advantage of growth opportunities in different geographic regions or industries.
• Your returns have the potential to be more predictable and smoother over the long term.

How can you be strategic in diversifying your portfolio?

You should know that diversification itself won’t necessarily assure you’ll earn a profit, nor does it guarantee against loss in a declining market. That’s why carefully evaluating where you’ll put your money is so important.

While building your strategy, be aware of economic trends. Of course, you want to include investments that are most likely to give you the greatest potential for growth, as well as those known for stability and dividend returns. Your goal shouldn’t be to invest in as many companies, industries and sectors as possible. But, you do want to add some variety in your holdings. Here are a few things to keep in mind.

 

1. Be careful not to spread your investments too thin. While you don’t want to “put all your eggs in one basket,” you also don’t want to diversify so much that staying current on your holdings becomes difficult. And, having many investments could mean you’ll probably need more frequent rebalancing. That could lead to increased transaction costs. This is precisely why some investors add ETFs, index funds and mutual funds to their portfolios or invest only in these types of funds.
2. Stay informed about what’s happening in the economy. Obviously, consumer buying habits affect how industries perform. Staying on top of changes in consumer preferences and how industries are trending is especially critical.
   
   Here’s a real-world example. In response to demands for more environmentally friendly products, auto makers began making electric and hybrid vehicles. That opened the door to growth for related products and services. If these vehicles become more popular than gas-powered ones, it could negatively impact the oil and gas industries. On the flip side, other products and services, like manufacturers of charging stations or batteries, could begin to see exceptional profits.
   
   Keep in mind, changes can happen faster than you’d expect. And sometimes, by the time certain economic trends become widely known, it can be challenging to make a change in your portfolio that will have a significant impact. That’s why it’s so important to diversify.
   
   
3. Be attentive to current events. Is anything happening in the world that could affect your investments? Are these changes likely to be short term, long term or permanent? What happened to commercial real estate as a result of the pandemic is a good example.
   
   At the height of the pandemic, a great many companies and government agencies switched workers to remote or hybrid schedules. Even as things improved, many continued this practice. Over time, many organizations decided they no longer needed as much office space. This resulted in a negative impact on the commercial real estate world. Even today, not all commercial real estate properties and management companies have completely recovered.
   
   It would have been hard to predict how long these conditions would last and to what extent the economy would be impacted at the beginning of the pandemic. But, being aware of how things were unfolding may have helped investors realize there might be negative consequences for commercial real estate investments.
   
   
4. Keep tabs on changes in technology. As technology grows and develops, it could mean tremendous growth in related products and services. But, it could also mean shelving formerly useful technologies.
   
   For many years, people subscribed to cable networks and used VCRs and DVDs to watch movies and other types of entertainment. With the advent of streaming services, the cable industry, brick-and-mortar video-rental businesses, producers of VCR and DVD machines and even the movie industry all experienced downturns. Some disappeared completely. On the other end of the spectrum, digital products and services experienced an explosion of growth. But then, as the market became saturated, that growth slowed.
   
   Those who were paying attention to what was happening may have fared better with their technology investments.
   
   
5. Pay attention to which securities are in your mutual funds, ETFs or index funds. These are great ways to diversify—all the work is done for you. But, if you invest in multiple mutual funds or ETFs, it’s important to know the top 10 or 20 securities in each fund. Why? Everyone wants to invest in the hot companies. And often, many funds will invest in some of the same companies. So, you could end up with too many investment dollars in a particular company or industry.
6. Consider your risk tolerance. Investors generally fall into 1 of 3 categories:
       a. conservative investors or those who are risk averse
       b. moderate investors who are willing to absorb a certain amount of risk
       c. those who are willing to be more aggressive, even if that means potentially higher risks
   
   Your age also may factor into this decision. If you’re closer to retirement you’ll probably want to be more conservative. Younger investors may be more aggressive, especially since they have more time to recover from any downturns.
   
   Once you’ve determined how much risk you’re willing to take and losses you’d be willing to absorb, research the stability and risk factors of the investments you’re considering. If you’re okay with a moderate amount of risk, for example, you may want to sprinkle in both higher risk and more conservative investments.

You’ll want to focus on steady, long-term growth. The market will fluctuate from time to time. But, a solid long-term strategy will help you take advantage of the high performers and weather the downturns. If you’re interested in learning about some specific investing strategies, our article, 7 Investing Strategies to Multiply Your Earnings, would be a good place to start.

What if you still have questions on how to diversify?

If you’re still uncertain about which approach to take, Navy Federal Investment Services can help.  Our Digital Investor^{Footnote 1} automated investing service can build you a portfolio based on your goals, preferences, finances and risk tolerance. And best of all, it automatically diversifies and periodically rebalances it.

If you’d prefer a more personal touch, our financial advisors can help you build a long-term strategy to help you reach all your financial goals. They can provide investment guidance, recommendations for an investing strategy and personal portfolio management. And, the first consultation won’t cost you a penny. You can find one near you by visiting our financial advisor locator page.