- Diversification is good for your portfolio as a whole, because it means you’re less reliant on one type of investment to do well
- In order to properly diversify, there are additional factors to take into consideration, like the type of equity investments and bonds you hold
If there’s one thing you know by now it’s that you want a diversified portfolio.
That means a mix of equity and bonds that suits your goals, and a mix of different investment classes within those, but even knowing that it can be hard to figure out if your portfolio is as diversified as it should be.
That’s why there’s one more layer of definitions that can help you get clear on what’s in your portfolio, and how diversified your investments really are.
Once you understand these asset class definitions, and how you can diversify within the big buckets of “equity” and “bonds”, you’ll be ready to read up on—and understand—your portfolio.
Importance of Equity Diversification
When it comes to equity investments, there are a few key distinctions you’ll want to keep in mind: size, country, and style.
One way to increase the diversification of your investments in companies is to make sure you’re investing in companies of different sizes.
Companies are usually broken down into three categories by size, and their size is determined by their market capitalization, or market cap for short. That’s the technical term for the value of the company, which is found by multiplying the number of outstanding shares in the company by the current share price.
- A small cap stock generally has a market capitalization of under $2 billion.
- A medium cap stock generally has a market capitalization between $2 billion and $10 billion.
- A large cap stock generally has a market capitalization over $10 billion.
Investing in all three can help diversify your portfolio because they can each experience different risk and return patterns.
For example, smaller, less-established companies tend to be more volatile than larger, more established companies—so you might experience higher returns, but they come with more risk as well.
There are two major types of equity investments you can make when it comes to the region you’re investing in: domestic and international.
Basically, a domestic investment is an investment in a company based in your country, and an international investment is one based in another country.
Simple enough, right?
When you’re building a portfolio of ETFs, which as we’ve covered before is a smart move to get exposure to hundreds of investments with a single ETF, you’ll also see a third category based on country: global.
A global ETF is one that contains stocks from both domestic and international companies.
In the same vein, you’ll also find domestic and international ETFs, built solely of equity investments of each type.
When you’re diversifying between international and domestic investments, it’s important to understand that they do differ when it comes to their risk levels: International investments expose you to currency fluctuations, and some international investments are more volatile than others.
There are two different investing styles you can diversify between when it comes to an ETF-based portfolio: growth and value.
Growth investing aims to invest in companies that are poised to outgrow the general market, whereas value investing aims to invest in companies whose stocks are relatively cheap based on an analysis of the company and the market it operates in.
You can find ETFs that are built to track indexes that are built on each investment style, which is a great way to expose your investments to each style without having to do the underlying analysis yourself.
Equity isn’t the only part of your portfolio that should be diversified, and bonds come with their own set of diversification opportunities.
Specifically, bonds can be diversified by their issuer, their credit rating, and their maturity date.
Bonds are generally issued by two types of organizations: companies and governments.
When companies issue bonds, there’s no guarantee of return on your principal investment, which means company-issued bonds are typically higher risk and come with a higher potential for return.
You’re relying on the company’s ability to pay back your money in the future.
On the other hand, many, but not all, government bonds are guaranteed to return the principal invested and can be backed by state, local, and national government.
That means they’re generally lower risk, but they also come with a lower return.
When you’re investing in bonds issued by a company, each company is given a rating based on their creditworthiness—similar to your personal credit score, but for companies.
Investment-grade bonds are issued by companies with a solid credit rating, which is typically a BBB- rating or above. That means it’s more likely that the companies will pay their debts, which in the case of bonds, means paying back the principal and the interest on your investment.
High-yield bonds come with a higher risk of default, because they’re rated BB+ or below. However, because they’re riskier, they typically offer a higher rate of return to attract investors.
Bonds are issued for different amounts of time, so you can diversify by the maturity date of the bond as well.
\When a bond matures, the issuer returns your principal—but remember that some bonds are riskier than others, so that’s not a guarantee, just a general rule.
- Short-term bonds generally mature within one to three years.
- Intermediate-term bonds generally mature between three to six years.
- Long-term bonds generally mature in six years or more.
When you’re thinking about your portfolio as a whole, consider that generally speaking the longer the term of the bond, the higher the risk relative to other bonds from the same issuer.
They’re more sensitive to interest rate changes, and your money is tied up for a longer time.
Ways to Diversify Your Portfolio
Diversification isn’t always reliant on one thing.
You can diversify by holding a mix of equity investments and bonds, but you can also diversify within your equity investments and your bonds as well.
A well-diversified portfolio is the best way to ensure you’re not putting all of your eggs into one basket, and to make sure you’re exposed to multiple types of investments.
That way, if one doesn’t do as well as another, you won’t be relying on just that investment for your return.
Investing 101: Let’s do this
Investing doesn’t have to be something scary and intimidating, and it’s one of the most powerful ways you can hit your goals and build wealth over the long term.
Make a Plan:
- Should I Save or Invest?
- Understanding the Stock Market
- Long-Term Investing
- The Relationship Between Risk and Return
- Investing for Beginners
- The Benefits of Diversifying Your Investments
- Types of Asset Classes
- 5 Common Investing Mistakes