“Don’t put all of your eggs in one basket” is a piece of advice that can apply to countless life situations.

For instance, say you own a local fruit stand where you sell the best oranges in town. Business is good, and your profits have increased steadily over the past few years. Then, a tree infection wipes out much of your fruit for the season. Because your entire business depends on your orange crop, unfortunately, your profits are significantly impacted.

Now, imagine if your business instead sold a variety of fruits and vegetables. Though your sales might see a minor drop during the orange shortage, because it’s only a fraction of your business, the rest of your fruit and vegetable profits would be protected.

While a fruit stand may seem like a far cry from the investments you pick as part of your total investment strategy, the same logic — a tactic known as diversification — can be applied when it comes to selecting and managing your portfolio.

Here’s what you should know about managing risk in your investments by using a diversification strategy.

How you may protect your investments through diversification

Individual securities can experience wild price fluctuations. One year, the shares could double. The next year, the value may fall by one-third.

Besides keeping you awake at night, putting all of your eggs in one investment basket opens you up to long-term risk if the investment loses most of its value — and doesn’t regain it.

Diversifying your assets over a number of different investments may help decrease the odds of this happening. For example, you may wish to invest in the four most common asset classes: stocks (equities), bonds (fixed income and debt), cash and money market accounts, and property and other tangible real estate assets. You may even want to invest in alternative assets such as REITs, foreign currency, venture and private equity funds, commodities, and art. But you don’t want to simply pick a few stocks and bonds or invest in others at random. Instead, it’s smart to choose those investments with the potential to minimize your risk and maximize your expected returns.

In general, there are two types of risk you should consider:

  • Systematic risk: This is the risk that comes from factors that affect an entire market, such as the economy and interest rates. It’s impossible to avoid this type of risk completely, but you may be able to reduce it with a proper asset allocation strategy — more on that later.
  • Unsystematic risk: This is the impact of factors that are specific to each individual investment. Examples include changes in management or the success or failure of new products offered by a particular company. You can minimize the unsystematic risk associated with an individual asset or company by investing in multiple assets and companies instead.

So, how can you apply all of this in practice? To answer that question, let's take a trip back to the 1950s.

Modern Portfolio Theory was groundbreaking for portfolio diversification

In 1952, Harry Markowitz wrote an article in the Journal of Finance in which he proposed a framework for diversifying away unsystematic risk. He called this framework Modern Portfolio Theory.

Markowitz asserted that an ideal portfolio — one with high returns and low risk — could be created by investing in assets whose price movements weren’t highly correlated.

Let’s say you have two stocks: Stock A and Stock B. Stock A typically does well when energy prices rise, where Stock B has no relation to energy at all. By purchasing both stocks of unrelated industries, you can potentially reduce the chances of losing money in these assets if energy prices dive.

While diversifying within the same asset class is often a wise decision, you may wish to take it a step further.

Investing in different asset classes can offer additional diversification benefits

While it may be easier to alleviate the effects of unsystematic risk, minimizing systematic risk typically is more difficult. However, it may be possible to minimize both risks by diversifying your assets across multiple asset classes.

For example, rather than holding all of your assets in stocks that may move in tandem, diversifying in other asset classes that don’t necessarily track market swings, like REITs, private equity, and art, can help lessen the impact of major market swings.

Each asset class has unique characteristics that may help reduce some systematic risk when held in the same portfolio. Below are some major asset classes to consider, and their general behaviors. Investing in any of these asset classes is not immune to risk, including illiquidity and a complete loss of capital. As you consider which asset classes should be part of your investment portfolio, you may want to consult with a financial advisor or conduct additional research.

  • Cash: Money held in money market funds or similar accounts offers low risk, but low reward. Its value is also reduced by inflation. However, it is readily accessible and can be a safe haven in times of turmoil.
  • Stocks or equities: Shares of ownership offered by publicly-traded companies often come with higher risk, but risk may be counterbalanced by the possibility of higher returns. The whiplash that the equity markets experienced in 2020 tells you all you need to know.
  • Bonds: Fixed-income investments typically offer moderate risk and moderate reward. Bonds often rise in value when equities decline and vice versa. Bonds are also highly sensitive to increases in interest rates and inflation.
  • Real estate: Typically either individual properties or funds that hold income-producing real estate assets (often accessed through real estate investment trusts or “REITs”) may produce equity-like returns with somewhat less risk. At the same time, their correlation with equities is lower than you may expect, giving them strong diversification benefits without necessarily sacrificing performance.
  • Commodities: Investments in resources, such as grains, gold and oil, may act as a hedge against inflation, making them a potentially powerful diversifier when economic growth is robust.

Are there cons to diversification?

Diversification may sound like a magic bullet that should be applied to every investment decision, but there are things to consider.

First, the flipside of lower risk means that it’s unlikely your investments will help you “get rich” quickly. Diversification is a “slow and steady wins the race” strategy, so it’s important to focus on the long view.

It also can be cumbersome to manage a diversified portfolio personally. Not only will you have to make the initial investment decisions — carefully considering the interactions among all securities — but you’ll also need to periodically rebalance your portfolio over time to maintain your proportional exposure to each asset asset class. Just be mindful that fees or expenses may be involved when you seek assistance from a financial professional.

Fortunately, you don’t have to personally manage your portfolio to reap the benefits of a diversification strategy. Here are a few other options:

  • Funds: You can invest in a mutual fund or index fund, which invests in baskets of securities, buying and selling as necessary.
  • Exchange-Traded Funds (ETFs): A basket of investments pooled together to give you access to specific industries or a broad index. ETFS are typically passive investments (as opposed to being actively managed), which helps to keep their fees low.
  • Certain REITs: Though some REITs give you concentrated exposure to certain properties or geographies, others reduce your risk by diversifying across property types and regions.

Summing it up

Diversification is one of the most important principles of investing. Though it has its limitations, diversification may help minimize both systematic and unsystematic risk to keep your portfolio strong enough to ride the waves of any given market.

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The views and opinions expressed in this commentary reflect Modiv Inc.’s (together with its affiliates, “Modiv”) beliefs and observations in commercial real estate as of the date of publication from sources believed by Modiv to be reliable and are subject to change. Modiv undertakes no responsibility to advise you of any changes in the views expressed herein. No representations are made as to the accuracy of such observations and assumptions and there can be no assurances that actual events will not differ materially from those assumed. The forward-looking statements in this paper are based on Modiv’s current expectations, estimates, forecasts and projections, and are not guarantees of future performance. Actual results may differ materially from those expressed in these forward-looking statements, and you should not place undue reliance on any such statements. These materials are provided for informational purposes only, and under no circumstances may any information contained herein be construed as investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any Modiv program or offering. Alternative investments, such as investments in real estate, can be highly illiquid, are speculative, may not be suitable for all investors, and there is no guarantee that distributions will be paid.