How to Measure Diversification in a Portfolio: Investing Like a Pro

We’re all familiar with the old adage, “Don’t put all your eggs in one basket.” This same principle applies to diversifying your investment portfolio. Owning a variety of assets that perform differently over different time horizons, and react differently to various economic events, helps minimize your level of risk and reduces your portfolio’s volatility.

Why Portfolio Diversification Works

It’s unlikely that several different assets would experience large losses at the same time (if the stock market falls, bonds are likely to still do well during a bear market), and this is why diversification yields such great results for investors month after month, year after year. In addition to minimizing your risk, the opposite is also true. A diversified portfolio exposes you to more opportunities for a positive return instead of limiting you to only one or two types of investments.

Consider tax diversification. This involves investing in different asset classes that are treated differently when it comes to taxes. A mix of tax-advantaged, fully-taxable, and tax-free investments can help lower your tax burden overall, both now and down the road as you inch your way closer to retirement.

How Do Financial Advisors Determine How Much Diversification a Portfolio Has or Needs?

Investment advisors take into account your comfort level with risk, what your goals are, and how much time you have to invest before they make recommendations on how to diversify your portfolio. How you allocate your assets should align with these factors, and advisors know exactly how to measure diversification in a portfolio.

Financial advisors can use portfolio standard deviation to calculate the volatility of your portfolio. This includes three factors: 

1. The standard deviation of each asset
2. The respective weight of that asset in your overall portfolio
3. The correlation between each pair of assets in your portfolio

In an ideal world, you’d have an overall positive return each year on your portfolio with an annualized standardized deviation of 0%. This means your portfolio would experience no volatility, with a bad year from one specific investment being equally offset by a good year from another. Although it rarely works out precisely that way in the real world, this concept for measuring diversification still helps reduce your portfolio’s volatility.

When recommending your asset allocation, historical data such as an asset’s average annual return, best and worst returns over 12-month periods, best and worst 20-year returns (annualized), as well as the investment’s historical rate of volatility, all represent important information that can help determine the best mix for your goals, timeframe, and risk tolerance.

For example, a conservative investor may want a diversified mix of 50% bonds, 30% short-term investments, 14% U.S. stock, and 6% foreign stock. On the other end of the spectrum, an investor looking for aggressive growth may be better served with a mix of 60% U.S. stocks, 25% foreign stocks, and 15% bonds.

How Can the Average Person Measure Their Portfolio’s Diversification on Their Own?

The average person can measure their portfolio’s diversification by looking at standard percentages for each type of asset for each type of investor (ranging from conservative investors to those looking for aggressive growth). This can be a tedious process, however, especially for those without a professional background in financial analysis. A financial advisor will have access to models and programs that can yield more precise results much more quickly.

How to Optimize Your Portfolio Diversification and Reduce Investment Risk

Deciding how to diversify your portfolio isn’t a one-and-done decision. Instead, it should be reevaluated and rebalanced periodically to ensure that it’s still in line with your goals, timeframe, and risk tolerance level. This also allows for any changes due to, for example, a shortened time frame to achieve one of your financial goals.

Additionally, diversification should not only involve diversifying individual assets, but also diversifying within the different asset categories. For instance, if you invest in stocks, you’ll probably want to choose at least a dozen individual stocks in different industries to diversify. Another way to diversify is with mutual funds, which invest in a large number of stocks. You’ll need to make sure, however, that the funds don’t stick to a single sector of stocks.

Portfolio optimization and diversification is important for the long-term success of your investments since it minimizes risk. Financial advisors know how to measure diversification in a portfolio and can recommend the best mix of assets to help you meet your financial goals. To get started on your portfolio, schedule a virtual intro meeting to connect with us and be sure to join our Retirement Income Academy Course!