Investing

Two Types of Diversification That Help Reduce Risk

Two Types of Diversification

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There are two main forms of diversification. Diversification by the TYPE of asset class and diversification WITHIN the asset class. Why does this matter? Let’s talk about it.

First let’s get an understanding of what I mean by asset class.

Asset Classes

The 6 main forms of asset classes are cash, fixed income (bonds), equities (stocks), real estate, commodities and alternative investments. 

Each of these asset classes provide you the opportunity to invest with varying degrees of risk associated with each of them.

Asset classes make up your asset allocation. An example of an asset allocation would be… 10% Cash, 20% Fixed Income, 60% Equities, 10% Alternative Investments. 

You are able to direct your asset allocation by diversifying your assets across multiple different asset classes in an effort to manage risk, liquidity needs and to achieve your financial goals. 

So before you invest in any one of these asset classes it’s important to have a general understanding of what they are, the risks associated with them and what type of income is generated from them. 

Diversifying By TYPE of Asset Class

Diversification by the TYPE of asset class is the process of investing across multiple different asset classes – cash, fixed income, equities, etc.

The ultimate goal of diversification is to reduce your exposure to risk but meanwhile maintaining the necessary opportunity to obtain a rate of return that will support your financial goals.  

For most of us, our retirement funds and future lifestyle will depend on our ability to earn an income – through our employment and also by way of our investments. Our investments will require a level of risk in order to achieve future goals. How you choose to diversify by asset class will indicate the level of risk you are willing to take and also your earning potential.

If you were to place all of your money into cash – you would have little to no risk at all and in turn, little to no reward. (Although one could argue, your risk is in the fact that you are holding all your assets in one asset class that is diminishing in value over time due to inflation).  

If you were to place all of your assets into equities – you would be exposing yourself to much greater risk with the potential for much more reward. 

Diversification by asset class is a balance of risk and reward through your selection of investments. 

There is not one specific asset class that outperforms another year in and year out. It will vary over time. No two asset classes respond and react in the same way to world events. Which is why diversification is key.

This link provides an excellent breakdown of asset class performance over the past 20 years and makes a strong case for the value that diversification provides.

Diversifying WITHIN the Asset Class

Then the next thing to consider once you have determined what level of risk you are willing to take on and your investment time horizon – you then drill down to determine how best to invest within that asset class.

A few examples of drilling down within each asset class would be the following:

Cash

You may not think cash is an investment, but holding your money in cash is an investment decision.

Cash is liquid, safe, readily available – typically held in a checking account or savings account with minimal interest being earned.

Cash alternatives offer the opportunity to earn a slightly higher interest rate than what you’d earn on your money in a checking account. 

  • Examples of cash alternatives would be High Yield Savings accounts, Certificate of Deposits (CDs), Treasury Bills or other short term cash investments.


Fixed Income

Fixed income is investing in other entities through financing their debt. You, as the investor, loan money to an issuer of a bond. This allows the issuer to finance whatever project it is they are working on and in return they promise to pay you your principal back and an income at fixed intervals at a fixed rate.  

Bonds are the main form of Fixed Income. They typically have reliable returns, a fixed and predictable income that provides a cash flow to you, along with less risk.  There are 3 major types of bonds and the biggest difference between them is who is issuing them and how they are taxed.

  • Municipal Bonds – is a bond issued by a state or local government to support state and local projects.
  • Government Bonds – the federal government needs funds for roads, infrastructure, defense, etc. and will raise money through government bonds to be able to afford such projects.
  • Corporate Bonds – a corporation will issue bonds to finance projects related to the ongoing operations of the company, growth projects, mergers & acquisitions, etc.

You are able to invest in bonds through Bond Funds or investing in individual bonds. A post for another day.

Real Estate

Investing in real estate could hold many forms. Purchasing commercial or residential real estate directly, investing in a Real Estate Investment Trust (REIT) in the stock market or pooling money together in the private funding of real estate projects.

Equities


When you invest in equities, you become a shareholder in the company or fund.  There are many ways to diversify within equities and for that reason, I will keep this short and go into detail at a later date.

A few ways to invest in equities:

  • Individual Stocks / ETFs / Mutual Funds

By Sector: Technology, Energy, Healthcare, Financials, etc.

By Region: United States, Europe, Emerging Markets, Asia, etc.

By Size of Company: Large Cap, Mid Cap, Small Cap or Micro Cap


The Point Is – You Have Options

The options are not laid out to overwhelm you. I don’t expect any one of you to be able to recite and feel confident in everything I just wrote about. But I do want you to know you have options and those options will provide you the opportunity to invest in a way that makes the most sense for you.

Not what the world is telling you to do. Or to just invest in the S&P 500 and forget about it. That may feel like too much risk for you, and that’s ok.

You also have options which will allow you to be exposed to a specific asset class without having to upfront a significant amount of money.

You may want to invest in real estate, but you may not have the funds to have the down payment for a physical property – consider a REIT.

You may want to invest in gold to hedge inflation but don’t want to go out and buy physical bricks of gold – consider a gold ETF.

You may want to have the opportunity for your assets to grow but want a certain level of security and faith that you will obtain your principal back, plus some – consider fixed income.

There are a variety of ways to invest your cash. Each direction you choose will have a different level of risk associated with it. Understand your risk tolerance, your time horizon and your future goals to identify how best to invest going forward.


Resources:

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