Why Is Diversification Important in an Investment Portfolio?

We often talk about why it is important to diversify your portfolio. But what does that really mean?

Most investors are taught that their 401(k)s are diversified because of their mix of stocks, bonds, and currencies.

When looking at the portfolios of institutional and ultra-wealthy investors, however, it becomes obvious that the most successful investors spread risk across a much wider variety of asset classes, including alternative investments with the opportunity for outsized returns.

Until recently, this portfolio diversification strategy was only available to the ultra-wealthy (e.g., those who could afford to invest in real estate by purchasing a condominium). But now individual investors can make similar investments on a smaller scale—and with the tax advantages of their retirement account.

Key Takeaways:

• Portfolio diversification means spreading out your investments across a variety of assets and industries.
• Diversifying your portfolio spreads risk, increases risk-adjusted returns, and may enhance peace of mind.
• There are two types of risk: Systematic and unsystematic. Systematic refers to the risk associated with the market as a whole while unsystematic refers to industry-specific risk.
• A 401(k) or target-date fund is not a diversified portfolio.
• Ultra-wealthy and institutional investors have long diversified their portfolios with alternative assets.

What Is Portfolio Diversification?

Portfolio diversification means spreading out your investments across a variety of asset classes so that one’s industry-specific decline will not bring down your whole portfolio. Especially during times of market volatility, cultivating a portfolio that includes a variety of assets can help reduce the potential for significant loss.

Here’s an example of what an average retirement portfolio might look like vs. a diversified portfolio:

Note: The above charts are solely for the purpose of illustration and should not be taken as investment advice.

The Benefits of Portfolio Diversification

There are several benefits to a diversified portfolio, including spreading risk, enhancing risk-adjusted returns, and creating peace of mind.

1. Spreads Risk

Before we get into how portfolio diversification spreads risk, it’s important to define the two types of risk:

• Systematic risk refers to the risk that is built into the market as a whole and reflects the impact of the economic, geopolitical, or financial environment; this type of risk is often difficult to avoid. The Great Recession of 2008 is an example of systematic risk, as markets drastically declined overall.
• Unsystematic risk refers to the risk that affects individual asset classes or specific industries. Some examples of unsystematic risk are union strikes, changes in an industry’s rules and regulations, or the recall of a product.

While systematic risk generally cannot be avoided, unsystematic risk can be mitigated through the use of portfolio diversification. In the case of a union strike, for example, an investor with a diversified portfolio would take less of a hit than someone who had invested solely in that particular industry.

2. Increases Risk-Adjusted Returns

Risk-adjusted return is a measure of the return an investment provides relative to the risk associated with it. In other words, while a particular asset may look like a solid investment, a second look factoring in the potential risk involved could reveal it to be highly volatile.

With smart portfolio diversification, an investor can boost risk-adjusted returns by investing in assets that are not correlated with—or even have an inverse relationship to—the public markets.

With alternative assets in particular that have the potential for outsized returns, this means that when one asset declines, your allocation may balance out the damage.

3. Allows for Some Peace of Mind

Public market volatility and inflation are top of mind for many investors, which can often cloud good judgment. Investors who are solely invested in public markets often panic during times of market volatility or inflationary pressure and check their portfolios incessantly, or take drastic measures.

An investor with a diversified portfolio can have more peace of mind when the market (or specific segments of the market) move dramatically, knowing their investments are spread over a variety of assets with varying correlations to the public markets.

Do Target-Date Funds in a 401(k) Lead to a Diversified Portfolio?

Target-date funds are mutual funds that automatically reallocate investments over time based on risk. The closer you are to the retirement date you set, the more conservative the allocation. Comprising 24% of all assets in 401(k) plans, target-date funds hold more funds than any other asset class.

While target-date funds seem diversified, the truth is that they usually only offer a variety of stocks and bonds available in the public markets. As a result, they often have less potential for outsized returns, as most growth typically occurs while companies are starting out (i.e., still private).

Not only do target-date funds lack true portfolio diversification, but they can also severely limit returns if they move too much money into bonds too quickly. In fact, some financial advisors recommend investing in a target-date fund that is five or 10 years later than you actually want to retire because of this common phenomenon.

Turning your investments on autopilot may be tempting, but actively participating and doing your research before investing can help you create the future you want. Alternative investments are a great place to start when seeking ways to truly diversify your portfolio

How Alternative Investments Create Portfolio Diversification

When you start looking into alternative investments, you’ll likely see the name “David F. Swensen” or at the very least, the phrase “Yale University endowment fund.”

That’s because Swensen, as the former Chief Investment Officer at Yale University, pioneered “The Yale Model,” an investment model whereby a portfolio is divided into five or six roughly equal amounts in different asset classes. The Yale endowment fund saw a 40.2% annual return in FY 2021 thanks in part to its alternative investment allocation.

This strategy isn’t exclusive to endowment funds, though.

Ultra-wealthy and institutional investors have long included alternative assets in their personal portfolio diversification strategy. They recognize that today it’s more important than ever to diversify beyond the declining 60/40 model (60% stocks and 40% bonds).

Diversify Your Portfolio with Alternative Assets

Now, everyone can create a diversified portfolio like ultra-wealthy and institutional investors. With Alto, you can invest in alternative assets like:

• Startups, private equity, venture capital, and other pre-IPO companies
• Residential and commercial real estate
• Farmland and other land or mineral rights
• Shares of collectibles and real assets like art, classic cars, sports memorabilia, and wine
• Crypto assets and funds

Reduce your exposure to public market volatility while creating the opportunity for outsized returns. Create an account today and get started building your portfolio diversification strategy.