Using Diversification to Reduce Volatility in Your Portfolio

We’ve said time and again that all investing involves risk. Sometimes you’ll lose money because of a poor investment decision, but oftentimes it’s just the overall direction of the market that brings your portfolio down. When the markets become volatile and rife with uncertainty, even the most stoic investors begin to question their choices.

Diversification is one of the easiest strategies to use to mitigate risk. You can diversify your portfolio in many ways, and it is often beneficial for you to use a combination of diversification tactics. Diversification aims to smooth out risk in a portfolio, letting some investments neutralize the negative performance of others.

Let’s start by diversifying your portfolio across asset classes. Most investors think of stocks and bonds—and if you’re following Henssler’s Ten Year Rule, you allocate money you need within the next 10 years into fixed investments like U.S. Treasury bonds to protect principal from the volatility of the stock market. Long-term money is invested for growth—usually in stocks. However, you can also diversify growth investments into real estate or commodities. Fixed investments may be in corporate or municipal bonds, with cash and cash equivalents for short-term needs.

Since stocks are most often used to help grow your wealth, you want to diversify across the industry sectors, such as Technology, Healthcare, Consumer Staples, Energy, etc. In a bull market, all sectors generally rise; however, when volatility comes into play because of inflation, politics, or economic cycle, many sectors are negatively correlated, meaning when one sector is in favor, other sectors may be down. Consumer Staples companies can generally weather inflation, while Technology tends to do well in expansionary economic environments. You may also want to diversify across capitalization, choosing some Small-Cap and Mid-Cap companies alongside your Large-Cap, blue-chip companies. You can also diversify among foreign and domestic companies, as they often grow at different rates at differing times.

Be aware there is a fine line of over-diversification—if own several stock positions in your brokerage account and several funds in your employer-sponsored retirement account, consider the underlying investments. If you have multiple Large-Cap mutual funds or exchange-traded funds, you may have a significant amount of overlap between the stocks inside the funds and the stocks you own. Not paying attention to the underlying investments can lead to a concentration in a particular sector or company.

One of the most overlooked types of diversification is the tax diversification of your investments, which can be achieved with the type of account you use for saving money. Retirement accounts, like IRAs or 401(k)s, are generally tax-deferred, meaning that money invested today is often pre-tax, with withdrawals generally taxed at standard income rates in retirement. Brokerage accounts are after-tax investments, and growth is taxed at favorable capital gains rates. Tax-free investments, like Roth IRAs and some Roth 401(k)s, are after-tax investments today, but withdrawals are tax free in retirement. This mix is important because once you start withdrawing your funds to live on, a certain amount will be eaten away by taxes owed, and pre-tax accounts require you to withdraw and pay taxes in retirement, so timing can become an issue. You’ve often heard us say that a $1 million Roth IRA is worth $1 million; however, a $1 million 401(k) is worth less because tax is owed when funds are withdrawn.

Diversification cannot solve all your investment problems, but it can go to great lengths in reducing the overall risk of investing. If you have questions on how to diversify your portfolio, the experts at Henssler Financial will be glad to help: