The performance of any asset class is never guaranteed. The assets which have performed very well in the past cannot give results in the future. Almost all asset classes have to go through cycles of ups and downs and sometimes even generate negative returns. Thus, you need a well-planned diversification strategy to mitigate your risk and make your portfolio growth curve smooth and less volatile. A good diversification strategy should be dynamic in nature i.e., it should not only include multiple asset classes but also keep on updating non-performing asset classes with performing asset classes from time to time.
In order to understand the importance of diversification strategy, let us evaluate the performance of three asset classes NASDAQ, gold, and long-term treasury.
Asset class | NASDAQ | Gold | Long term treasury |
2018 | -1.04% | -1.15% | -1.90% |
2019 | 37.96% | 18.83% | 14.13% |
2020 | 47.58 | 24.43% | 18.29% |
2021 | 26.63% | -3.51% | -4.73% |
2022 | -32.97% | -0.23% | -29.58% |
78.16% | 45.85% | 0.21% |
Had your investment in only one asset class you very well see the volatility. If you were invested in long-term treasury you would have generated almost zero return in 5 years. The point is that you would have never predicted that NASDAQ would generate 78% and long-term treasury just 0.21% return five years back. So, what’s the way out? Diversification strategy can be a good solution in such a situation.
Now let us see if you would have invested equally in all three asset classes, what would be the results:
Asset class | NASDAQ (33.33%) Gold (33.33%) Long-term treasury (33.33%) |
2018 | -1.33% |
2019 | 23.64% |
2020 | 30.10% |
2021 | 6.13% |
2022 | -20.93 |
37.61% |
As per BlackRock asset return map.
You can note that yearly volatility is reduced significantly along with generating a decent return of 37.61% which is 7.522% APY.
Asset classes to include in a good diversification strategy
A good portfolio should be a blend of various asset classes like bonds, stocks, mutual funds, commodities, certificates of deposits (CDs), etc. because each asset class has its own risk profile, gain potential, and liquidity. By adjusting their proportion, you can easily archive the desired risk-reward ratio and liquidity in your portfolio.
Some important asset classes are as follows:
Stocks
Stock is a highly preferred asset class during a bull market and beginner investors are sometimes lured by their high reward potential. However, allocating the majority of the portfolio to individual stock should never be a part of a good diversification strategy because of the potential high risk. Instead, you can consider investing in multiple good quality stocks from different sectors to mitigate some risk in the long run. ETFs are also a good option because of inherent diversification.
Bonds
Being fixed-income instruments, bonds must be included in your portfolio. Bonds are basically funds raised by the government or corporations for a specific project. They are less risky compared to shares and offer some defense to your portfolio. They are also less sensitive to economic downturns.
Commodities
Commodities include assets like metals, crude oil, agricultural products, etc. Including this asset class in a portfolio can be a good approach because less correlation between bonds and stocks. It can also provide a hedge against inflation because the price of most of the commodities has a positive correlation with inflation. Investments can be made with the help of future contracts, ETFs mutual funds, or even physical holdings like gold.
Note: Investing in shares of a company dealing with a particular company vs. investing in that particular commodity are two completely different things.
Cash equivalents
Including cash equivalents in a portfolio as part of a diversification strategy can be useful to induce the required liquidity in a portfolio. This asset class has a low return profile and very low risk. Cash equivalents include certificates of deposits (CDs), marketable securities (though securities have maturity periods but marketable securities are actively traded), money market funds, and commercial papers.
Real estate
Real estate involves investing in land, properties, offices, farmhouses, etc. You must include real estate in your diversification strategy because of its less correlation with stocks and bonds and also it can be a source of regular income from rentals. Traditional real estate investment has high barriers and low liquidity. You can easily invest in real estate through Real Estate Investment Groups (REIGs) and Real Estate Investment Trusts (REITS). They can also be a good hedging instrument against inflation. REITS and REIGS not only lower the entry barrier but also induce required liquidity.
Important factor to consider while making diversification strategy
Sector breakdown
Even if you are investing in multiple assets you are investing in the same sector unknowingly. Thus, make sure your portfolio includes multiple sectors like energy, communication, healthcare, information technology, heavy metal, utilities, biotech, industrials, consumer discretionary, and FMCG. Many sectors are also cyclical in nature so entry in such sectors like steel sector should be a calculated decision instead of a random entry. You can also invest through sector-specific funds like ETFs and mutual funds if you do not have much time to track markets on a regular basis.
Hedge against inflation
There are certain asset classes that have a positive correlation with inflation, thus including them in a portfolio can help to catch the inflation. The most common instruments are REITS, TIPS, and commodities. You can easily invest in them using gold ETFs (GLD). TIPS or treasury inflation-protected securities are also extremely helpful in hedging against inflation.
Cryptocurrency as a new asset class
Though crypto assets are highly volatile because of uncertain policies and a globally inconsistent regulatory environment, they still posses very high potential. Being an emerging asset, it can generate insane returns. However, asset allocation should always be kept under control because of the high volatility and risk profile.
The diversification strategy must consider your age
The purpose of diversification is not only to mitigate risk but also to generate good returns whenever possible. You need to adopt a defensive approach as you age. If you follow defensive strategies from the start then you cannot expect good rewards. You can simply follow Rule of 100 which involves calculating how much to invest in equity based on your age. The rule of 100 says subtract your age from 100 and keep that much amount in equity. e.g., if your age is 40 you should keep 60% of your portfolio in equity. This way your portfolio would move from high-risk high reward investment to low-risk low reward investment gradually.
