Investing in the stock market is one way of accumulating wealth. And once you dip your hands in the investment ocean, the next logical step is to reduce your risk of losing your investment. And how to do that? One method is diversification.

By diversifying, you put your money on several kinds of assets, so if one asset goes down, the loss is offset by the other assets who haven’t been affected.

You can reduce the overall risk associated with your investment portfolio through strategic and thoughtful diversification.

Benjamin Graham, widely regarded as Warren Buffett’s mentor, expanded on the merits of diversification in his best-selling book “The Intelligent Investor” (1949).

“There is a close logical connection between the concept of a safety margin and the principle of diversification.” — Benjamin Graham 

Sir John Templeton, too, believed in diversification and rightfully said, “Diversify. In stocks and bonds, as in much else, there is safety in numbers.” Let us follow this apt adage and learn how to diversify your stock portfolio.

Why diversify?

The goal of diversification is to reach an optimal risk-to-reward ratio. It is meant to reduce the volatility of the portfolio despite swings in the market in either direction, up or down.

Through a reduction in exposure to a single stock or company or even an asset class, the impact of price movement on the portfolio value as a whole is reduced. Further, through diversification, in a variety of asset classes or sectors, exposure to Unsystematic Risk, i.e. risk related to a specific company or industry, can be reduced. As a result, the overall risk (or volatility) of a portfolio can be reduced at a given return expectation.

It is important to note that the goal of diversification is not to maximise the absolute returns of a portfolio but rather to optimise the risk-return economics of a portfolio.

What are the different types of portfolio diversification?

• Across Time Frames

Consider the time range that an investment operates in while making your decision. Due to their higher inherent risk, long-term bonds can occasionally provide higher rates of return; nevertheless, short-term investments are more liquid but offer lesser returns. The overall investment maturity length of the portfolio also supports diversification.

For instance, if you have a 10-year fixed deposit, the liquidity aspect would be most impacted because your money will be restricted until the end of that period. Of course, you are free to take money out at any moment before maturity, but you will be charged fees and get considerably less money than if you had waited.

Whereas diversifying your investments by choosing fixed deposits with different maturities, such as 2, 3, 5, or 10 years will protect you from the liquidity factor.

• Across Asset Classes

Portfolio diversification across asset classes refers to the distribution of your investments among various asset classes, such as equities, bonds, gold, silver, mutual funds, and fixed or recurring deposits.

Depending on the broader macroeconomic situation, various asset categories react in different ways. 

Alternative assets are an emerging asset class that goes beyond purchasing stocks and bonds.

Real estate, cryptocurrencies, commodities, precious metals, and other assets are now straightforward for investors to invest in, thanks to the advancement of digital technology.

• Across Borders

A portfolio’s geographic location is crucial to its diversity. You can take advantage of currency changes by investing in the shares or assets of one or more nations if the rules permit.

You can also invest in real estate abroad. Political, geopolitical, and international challenges have a greater impact on the policies of larger nations. 

The monetary policies of the various countries will, however, affect the opportunities and hazards in different ways. Thus, regional portfolio diversification helps you to acquire advantages and lower risks.

• Across Sectors

A significant level of industry diversity may be obtained by purchasing the stocks or bonds of businesses operating across various industries. Stocks can be categorised by sector or industry.

The S&P 500 index, for instance, consists of equities from businesses operating in 11 distinct industries. Businesses in the real estate and finance industries suffered enormous losses during the Great Recession of 2007–2009. Losses in the healthcare and utility sectors, however, were less large. Industry variety is a key strategy for reducing investment risk.

Why should you diversify your stock portfolio using an ETF?

Exchange-traded funds are normally passively managed. A fund manager selects the stocks and bonds for the fund in the first scenario. Instead of actively selecting stocks, the method just watches an index. 

Active funds, however, seek to outperform market returns. However, active managers did quite poorly in the previous year. Over 80% of all actively managed U.S. stock mutual funds lagged by their benchmark in 2021, according to S&P Dow Jones Indices. 

Some stock sub-categories were worse. About 85% of American large-cap stock funds underperformed the S&P 500, which is the second-worst percentage ever.

ETFs and index funds are a much simpler alternative here. They also offer lower expense ratios, a fee that mutual fund companies charge to manage your money, than actively managed mutual funds. 

You’ll often find that ETFs are less expensive when compared to index funds. ETFs have proven to be a solid financial product in terms of returns and costs, so let us further understand the advantages if we diversify a stock portfolio using ETFs:

1. Unlike mutual funds, exchange-traded funds (ETFs) can be easily traded like stocks before the market ends.
2. Since many ETFs are passively managed investments linked to an underlying index or market sector, their expense ratios usually tend to be lower than those of mutual funds. On the other hand, mutual funds are often handled more aggressively.
3. Using ETFs rather than stocks can provide immediate diversification. An ETF that tracks an index for financial services, for example, enables you to buy many financial firm stocks instead of just one. 
4. And of course, ETFs can be invested across time, geography, assets and sectors,  as mentioned before. This gives you the advantage of mitigating risks that can be found in one category while reaping the benefits in another.

How to Diversify your Stock Portfolio Using ETFs 

Exchange-Traded Funds (ETFs) are an attractive vehicle to diversify your portfolio. The ETF industry has exploded in popularity over the years and offers a lot of opportunities to diversify your portfolio.

Diversification through ETFs can be done in a variety of ways. In the section below, we cover a preferred way to diversify through investing in three asset classes and also provide options for implementation through leading ETFs. Let us understand how to diversify your investment portfolio below:

• Domestic Equities

Equity markets are often the aggressive part of a portfolio and offer high growth potential in the long term. Equities can substantially increase the volatility of portfolios in times of stress, like in the current market conditions. However, historical analyses show the U.S. market to be extremely resilient and rewarding over the long term.