Why your portfolio might not be (truly) diversified

If there’s such a thing as a universally known term in investing, “diversify your portfolio” might be as close as it gets. 

We certainly hear it a lot. Even non-investors get the basic concept: Spread your eggs into different baskets so, if you drop one, it doesn’t crack all your eggs. 

Simple enough, right?

In investing, diversification traditionally meant owning different stocks (equities) so that your risk wouldn’t be tied to the success, or failure, of just one company—or a concentration of companies. 

True diversification, or rather better diversification, is quite a bit more nuanced—and you might be surprised to learn many common investing strategies are taking on way more risk than you might think.

Understanding the limits of the stock market

Diversification of stocks can help reduce the risk tied to individual companies, but it can’t protect you from market-wide downturns. When the whole market drops, often many stocks drop together, even if your portfolio is “diversified” in the traditional sense.

Why is that? Today there are fewer than 3,500 companies traded on domestic public exchanges. That’s down from a peak of more than 8,000 in 1996. 

Because there are fewer companies to invest in (and just seven providing most of the returns), that means just about every publicly traded stock is, more or less, following the lead of the biggest names. That’s a huge liability when managing portfolio risk.

So where else can you turn to (truly) diversify your portfolio?

Adding fixed income to your portfolio

Adding bonds (fixed income) to your portfolio is generally seen as a way to lower risk, especially in a high-interest-rate environment. Bonds can offer good returns, sometimes even as high as stocks, and they’re typically a safer investment within a company’s financial structure. 

If the business fails, bondholders usually get back some of their investment, unlike stockholders. At EdgeRock, we don’t replace stocks with bonds, but we do include them in portfolio allocations for their potential to provide solid returns with less risk.

Going beyond public markets

True diversification goes further. It involves investing in different types of assets—not just stocks and bonds. This helps balance the risks and rewards in your portfolio. You might sometimes hear these options called “alternative investments,” but there’s nothing odd or new about them. 

What advisors mean by alternative is that they’re low-access, exclusive, and not traded in public markets. As public investment has consolidated in recent years, private investment has exploded to meet the risk diversification demands of high-net-worth investors—and increasingly middle-income families too! 

Asset classes like private equity, private credit, real estate, and infrastructure are quickly becoming a much larger proportion of advanced portfolio designs. Their purpose is to provide “independent” or “non-correlated” returns, so that an investor isn’t assuming all the downside risk of public markets. That way, when a sudden news story sends the New York Stock Exchange spiraling, a portion of your portfolio isn’t necessarily tumbling with it.

Less liquid can equal higher returns

Because private investments don’t trade on public markets, their prices won’t fluctuate daily like you see on a stock ticker. This can make your portfolio seem less volatile, which can be a nice change-of-pace if you’ve grown weary of riding the emotional roller coaster of the stock market.

The trade-off is these kinds of investments are often less liquid, meaning you can’t sell them easily. In exchange, they should offer higher returns, which can be really beneficial if you don’t have short-term needs for those savings.

Diversifying through different investment managers

Whether you’re investing in private or public markets, picking the right money managers is also a form of diversification. For public markets, this debate often centers around active vs. passive management. Passive funds, like ETFs, track market indexes and are generally cheaper and more tax-efficient. However, they mirror the risks of those indexes. 

Active managers, especially in less-followed markets like small- or mid-cap stocks, can sometimes outperform these indexes because they can take advantage of market inefficiencies. These managers may charge more, but they can be worth it for the potentially higher returns and lower risk.

“So, is my portfolio truly diversified?”

This is a question too many people don’t know to ask. Because most advisors, if you were to ask, will give you an answer like, “Sure—look how many different stocks you’re invested in! And look—we’ve got some bonds in there too! See? Diversity!” 

But as we’ve discussed, a bigger basket with more eggs is still…just a single basket of eggs. The same advisors will be making excuses when a single negative market event issues a uniform blow to your entire retirement savings.

The good news is downside exposure can be measured. (It’s just math.) If an advisor has the right experience, tools, and access, a portfolio can be built to address your investment goals without taking on the entire risk of the stock market, and that’s the kind of care and attention you should expect for your savings.

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