“Don’t put all your eggs in one basket” is a proverb that warns against investing all of your resources in a single source. If something were to happen to that basket, you’d lose all of your eggs. To mitigate that risk, it’s wise to spread out your assets. When applied to investing, this proverb directly speaks to the value of portfolio diversification.
Diversification
is an investment technique that aims to increase returns and decrease overall risk by allocating capital across investment types and industries. Whether you’re an aspiring portfolio manager or an investor curious about how your portfolio is constructed, it’s crucial to understand diversification’s value in the investment world.
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Why Build a Diversified Portfolio?
Portfolio diversification is based on the concept of complementarity, which describes the degree to which two or more assets move in opposite directions in specific environments or scenarios.
By selecting complementary investments, you can decrease a portfolio’s risk profile, regardless of the risk profiles of the investments it comprises. For example, imagine you’re a portfolio manager and choose to invest in two stocks: Investment A and Investment B. Investment A is in a package delivery company, and Investment B is in a videoconferencing platform company. Even if both investments are highly risky, the fact that they’re not in closely related industries decreases the portfolio’s overall risk.
For instance, if there were a gas shortage and the company couldn’t deliver packages, Investment A’s stock price might drop. Yet, Investment B’s stock price could increase, as videoconferencing wouldn’t be negatively impacted by a gas shortage. The gas shortage might even cause some people to work from home and purchase the videoconferencing platform, which could result in Investment B’s performance being negatively correlated with Investment A. You’re effectively putting your “eggs” (capital) in separate “baskets” (investments) to spread out risk.
Related: What Is Sustainable Investing?
3 Strategies for Portfolio Diversification
There are three primary strategies for portfolio diversification, and a wise portfolio manager considers all three.
1. Individual Asset Diversification
The first strategy is to invest in an array of assets within an asset class. This can be as simple as buying the market index—the S&P 500 or the Russell 2000—to ensure a variety of high- and low-risk stocks across industries are equally represented in your portfolio. It can also mean consciously investing in industries that seem complementary to one another.
2. International Market Diversification
The second strategy is to look abroad. If your country’s market were to perform poorly, it’s useful to have some investments in international markets to mitigate risk and balance your portfolio. Keep in mind that other countries may have different rules, regulations, and processes for investing than your country does.
3. Asset Class Diversification
The third strategy is to diversify by investing across asset classes. These can include traditional investments—such as stocks, bonds, and cash—which operate in the public market, and alternative investments, which primarily operate in the private market and are largely unregulated.
Alternative investments can be a beneficial addition to portfolios due to their high level of complementarity with traditional investments. Here’s a closer look at what alternative investments are and how to use them to diversify portfolios.
What Are Alternative Investments?
Alternative investments are any investment besides stocks, bonds, and cash. Alternatives are relatively illiquid—meaning they can’t be easily converted into cash—and unregulated by the United States Securities and Exchange Commission (SEC).
Some of the most common types of alternative investments include:
- Hedge funds, which pool the capital of many investors and invest it across various securities with the intention of managing risk to outperform the market’s rate of return.
- Private equity, which is the investment of capital in private companies and encompasses venture capital, growth equity, and buyouts.
- Real estate, which is the investment of capital in residential, commercial, or retail properties, either individually or through a real estate venture fund or investment trust.
- Debt investing, in which capital is invested in the debt of a private company and can be distressed or private.
- Commodities, in which capital is invested in natural resources, such as oil, agricultural products, or timber.
- Collectibles, in which items such as rare wines, cars, and baseball cards are purchased with the intention of selling them when their value appreciates.
- Structured products, which involve fixed-income markets and derivatives.
Alternative investments are a wise addition to portfolios because they tend to have a low correlation with traditional assets. This means that if the stock market is doing poorly, some of your alternative investments could perform well. Because these investments are separate from the public market, they present a great opportunity to diversify your portfolio.
Related: The Future of the Alternative Investments Industry
Factors to Consider for Diversified Portfolios
The alternative investment asset class contains a variety of asset types, each with unique characteristics. How do you know which are the best fit for your portfolio? Several factors can help you decide. Compare each alternative type to the traditional investment types in your portfolio to ensure diversification.
Time Horizon & Liquidity
Time horizon is the amount of time an investor can expect to hold a specific investment. Time horizons vary greatly, ranging from a few hours to a few decades. Liquidity is tied to time horizon; if an investment has a long time horizon, it’s considered illiquid until it reaches maturity.
Traditional investments (stocks, bonds, and cash) have no set time horizon and are fully liquid. Investors can cash in their investments whenever they decide to.
Alternative investments are relatively illiquid and have much longer time horizons. For some alternatives, time horizons are set at the signing of a contract; for instance, when someone becomes a limited partner at a private equity firm. Others are long simply because they’re difficult to sell or require time to accrue value. Here are a few examples:
- Hedge funds: Because hedge funds invest across various asset classes, their time horizons can be extremely short (a few seconds) to moderately long (a few years).
- Private equity: Private equity’s time horizons are typically around 10 years.
- Real estate: Institutional investors hold real estate investments for nearly eight years on average. Individual real estate investors aren’t tied to a specific time horizon, but it can be difficult to move a real estate asset quickly, depending on how the market is performing.
- Commodities and Collectibles: Commodities and collectibles have long, flexible time horizons, as they both require time to accrue value. You need to watch the trends in your asset’s specific market to know when it’s best to sell.
Building a portfolio that includes a variety of time horizons and liquidity provides both flexibility and security to its investors.
Markets & Industries
To diversify your portfolio, select investments from various industries and markets. When investing in private equity or debt investments, explore industry trends for the private companies you’re considering and select companies in industries with a high level of complementarity. When considering real estate investments, spread out your capital between several types of real estate or geographic locations.
Risks & Potential Threats
Spreading out risk is one of the key goals of diversification, and alternative investments provide varying levels of risk to consider. Returning to the concept of time horizons, investment options with longer time horizons are typically less risky because the market has time to correct itself should a downturn occur. If, however, your investment is a physical asset—such as a building, natural resource, or collectible—a longer time horizon means more time for the asset to be damaged, stolen, or lost, which adds additional risk.
Consider the types and levels of risk already present in your portfolio and choose investments that complement them.
Using Alternative Investments to Diversify Portfolios
Alternative investments are key to a strong, diversified portfolio. Understanding the time horizons, liquidity, industry and market trends, and risk level of each type can help you select alternatives that mitigate your portfolio’s overall risk and increase returns.
Gaining a deeper understanding of each alternative investment type can serve you well as an aspiring portfolio manager. Consider taking an online course like Alternative Investments to build your knowledge base and sharpen your intuition for which investments are the best fit for a well-rounded, diversified portfolio.
Are you interested in learning how to build strong investment portfolios? Explore our five-week online course Alternative Investments and other finance and accounting courses.
