Portfolio allocation is one of the most critical aspects of investing, influencing both risk and potential returns. However, many investors, both novices and experienced ones, often make a common mistake in their portfolio allocation: lack of diversification.

Sounds like Investing 101, right? Well, I’ve known a lot of supposedly seasoned investors who forget this basic rule. Sometimes, we all need to be reminded of the essentials. So, let’s examine this common error and how to rectify it.

Below, I explore why diversification is crucial, the reasons behind poor allocation decisions, and practical strategies to rectify these mistakes for a more balanced and resilient investment portfolio.

Diversification is the practice of spreading investments across various asset classes, sectors, and geographical regions to reduce exposure to any single asset or market risk.

The idea is simple: “Don’t put all your eggs in one basket.” By diversifying, investors can potentially reduce the impact of poor performance in one investment area on their overall portfolio, leading to more stable returns over time.

Historically, different asset classes, such as stocks, bonds, real estate, and commodities, have exhibited different performance patterns. For instance, when stock markets face volatility and downturns, bonds often act as a safer haven, offering more stable returns.

Similarly, geographical diversification can protect against regional economic downturns, as markets in different countries or regions may not move in the same direction at the same time.

One of the most prevalent mistakes investors make is over-concentration, or putting too much capital into a single asset class, sector, or even individual stock. This mistake can occur due to various reasons.

Many investors have a preference for investing in domestic markets or companies they are familiar with. While familiarity provides comfort, it also limits exposure to potentially higher-growth opportunities available in foreign markets.

Investors often flock to assets or sectors that have recently performed well, leading to overexposure in those areas. For example, during the tech boom, many portfolios were heavily skewed towards technology stocks, ignoring the importance of balance.

Some investors might not fully understand the importance of diversification and may unknowingly build portfolios concentrated in one sector, such as energy, real estate, or tech, based on personal preferences or trends.

Emotions play a significant role in investment decisions. Fear of missing out (FOMO) can lead to over-concentration in trending sectors or stocks, while fear and panic during downturns can cause investors to exit positions and move entirely into cash, missing recovery opportunities.

How to Rectify Poor Portfolio Allocation

To build a well-diversified portfolio and mitigate the risks associated with over-concentration, investors can follow these practical steps:

• Determine Your Risk Tolerance and Investment Goals.

Understanding your risk tolerance is crucial in deciding how to allocate your portfolio. Younger investors with a longer time horizon may afford to take more risks and allocate a larger portion to equities.

In contrast, those nearing retirement might prefer a more conservative allocation with a higher focus on bonds and income-generating assets. Clearly defining your investment goals and time horizon will help shape the overall asset allocation.

• Diversify Across Asset Classes.

A balanced portfolio should include a mix of asset classes, such as stocks, bonds, real estate, commodities, and cash. Stocks typically offer higher potential returns but come with more volatility.

Our flagship publication, Personal Finance, recommends the following portfolio allocations under the current investment conditions (see pie chart).

Of course, these percentages are just rough guidelines and you should tailor them to your stage of life and tolerance for risk.

Bonds provide more stability and regular income, acting as a counterbalance during stock market downturns.

Real estate, commodities and precious metals (e.g., gold and silver) can offer additional diversification, providing exposure to non-correlated assets that can hedge against inflation.

• Diversify Within Asset Classes.

Within each asset class, diversification is equally important. For equities, diversify across different sectors (technology, health care, finance, consumer goods, etc.) and market capitalizations (large-cap, mid-cap, small-cap).

For bonds, consider varying maturities, credit qualities, and issuers (government vs. corporate). This approach helps spread risk and reduce exposure to sector-specific or issuer-specific downturns.

• Consider International Exposure.

Including international investments in a portfolio can provide exposure to faster-growing economies and different market cycles. Emerging markets often offer higher growth potential, while developed markets provide stability.

International diversification also mitigates the risk of underperformance in domestic markets due to economic slowdowns or political issues.

• Rebalance Regularly.

Over time, market movements can cause the original asset allocation to shift, resulting in unintended over-concentration. For example, a booming stock market might increase the equity portion of a portfolio, while a downturn might overly increase the bond allocation.

Regularly rebalancing the portfolio back to the target allocation ensures that the investor’s risk level and diversification are maintained. Rebalancing typically involves selling high-performing assets and buying underperforming ones to restore balance.

• Use Diversified Investment Vehicles.

Exchange-traded funds (ETFs) and mutual funds are excellent tools for diversification. They offer exposure to a wide range of assets within a single investment.

For example, an S&P 500 index fund provides broad exposure to large-cap U.S. stocks, while a bond fund can offer a diversified mix of corporate and government bonds. Sector-specific and international ETFs can further enhance diversification.

Read This Story: How to Beat Wall Street…Under All Investing Conditions

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John Persinos is the editorial director of Investing Daily.

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