How does diversification work?

“Don’t put all of your eggs in one basket” is one of the oldest financial sayings in investing. It’s about diversification, risk, and your portfolio. In this post, we’ll define diversification, why to consider the strategy, how to rebalance a diversified portfolio, and the different types of diversification available to investors.

What is diversification?

Diversification is a fundamental strategy of spreading investments across various assets to potentially reduce risk exposure.  

By holding a mix of investments with different risk and return profiles, diversification aims to minimize the impact of poor-performing assets on the overall portfolio and increase the chances of achieving a more balanced and stable long-term return on your investment.

Diversification on M1

The M1 platform is built on diversification. M1 Pies are customizable portfolios that allow you to diversify your investments according to your financial goals and risk tolerance. 

Creating a diversified portfolio on M1 is as easy as pie! You can select from a wide range of pre-built model pies or design your own to suit your unique investment preferences. These pies can consist of stocks or ETFs offering you the flexibility to tailor your diversification strategy. 

Diversifying your investments using M1 Pies not only could help spread your risk but also allows you to maintain a well-balanced portfolio that aligns with your financial objectives. Whether you’re a conservative investor or looking for higher growth potential, M1 Pies can assist you in achieving your desired level of diversification.

Why to consider diversification in your portfolio

One of the primary reasons to consider diversification is potential risk management. When you invest in a single asset or asset class, your returns are heavily dependent on the performance of that specific investment. If that asset or asset class fails, your losses could be heavily concentrated.  

Diversification spreads this risk, which could potentially reduce the impact of a poor-performing investment on your overall portfolio. 

Different asset classes have varying levels of risk and return. For example, some assets may be more volatile but offer higher potential returns, while others could be less risky but come with lower potential returns. By diversifying your portfolio, you can aim for a balance between risk and return that aligns with your financial goals. 

A classic example of diversification that many financial advisors use is the 60/40 portfolio. This diversified portfolio allocates 60% to stocks and 40% to bonds and is typically thought to be of moderate risk. 

Diversification can also help possibly mitigate the volatility of your investments. While one asset might experience a sharp drop in value, another might be performing well. This balance can help stabilize your portfolio’s overall performance, making it less susceptible to extreme fluctuations.

Diversification and rebalancing

Like any investment strategy, diversification requires you to periodically update and maintain your portfolio. This is called rebalancing. Rebalancing involves adjusting the allocation of your assets to ensure they remain in line with your investment goals. 

For example, let’s say you initially set a target allocation of 60% in stocks and 40% in bonds. Over time, due to market fluctuations, your portfolio may shift to 65% in stocks and 35% in bonds. This is due to the value of the assets within the portfolio changing, creating differing returns. Rebalancing would involve selling some stocks and buying more bonds to bring your portfolio back to your desired 60/40 allocation. It is important to note that M1 does not offer bonds on the platform. 

Rebalancing helps maintain your desired risk and return profile and prevents your portfolio from becoming too heavily weighted in a single asset class.

Dynamic rebalancing and diversification on M1

M1 offers a unique feature known as Dynamic Rebalancing, which simplifies the rebalancing process.  

With M1’s Dynamic Rebalancing, every trade with new cash in your portfolio pushes you closer to the target percentages you set. This means you can invest cash into your Pie and maintain your investment targets without any manual calculations. 

Our trading system can automatically sell assets that are overrepresented in your portfolio and buy assets that are underrepresented in your portfolio, thus helping align your portfolio to your desired level of diversification. 

Whenever your account makes new trades, the algorithm identifies slices that are most relatively underweight and puts money into those first. When removing cash from a portfolio, the algorithm identifies slices that are most relatively overweight and removes money from those first. This dynamic approach helps you effortlessly maintain your desired diversification, even in changing market conditions.

Types of diversification

When diversifying your portfolio, you can diversify by asset class and within asset class.

Diversification by asset class

Here are some common asset classes that you can diversify within:

Stocks

Stocks represent ownership in publicly traded companies and can provide diversification by adding equity exposure to a portfolio. 

ETFs

ETFs are investment funds that offer diversification by tracking various indexes, commodities, or sectors, making them a convenient way to spread risk.

Bonds

Bonds are debt instruments issued by governments or corporations, providing diversification through fixed income and lower risk compared to stocks. 

Crypto

Cryptocurrencies are digital assets that can add diversification by offering an alternative asset class with low correlation to traditional investments. 

Real estate

Real estate investments diversify by including physical properties, providing potential rental income and appreciation to a portfolio. 

Commodities

Diversify through commodities by including essential goods used in production, such as oil, gold, or agricultural products. 

Cash

Cash and cash equivalents represent low-risk, liquid assets like Treasury bills and money market instruments that provide diversification by adding stability and liquidity to a portfolio. 

Diversification within asset class

Diversification can also occur within the same asset class. Here are a few ways you can diversify within an asset class:

Diversification within Stocks and ETFs

• Investing in a mix of large-cap, mid-cap, and small-cap stocks can potentially spread risk across different market capitalizations. 
• Consider different sectors, such as technology, healthcare, consumer goods, and finance, to diversify within the stock market. 
• Explore international stocks and invest in companies from various countries to reduce geographic risk. 

Diversification within Bonds 

• Investing in bonds with different maturities, including short-term, intermediate-term, and long-term bonds can potentially increase diversification. 
• Consider bonds issued by various entities, such as government bonds, municipal bonds, and corporate bonds, to spread credit risk. 
• Explore bonds with different credit qualities, including investment-grade and high-yield (junk) bonds, to balance risk and return. 

Diversification within Crypto

• Investing in a range of cryptocurrencies, such as Bitcoin, Ethereum, Litecoin, and others, can potentially spread risk across different digital assets. 
• Explore various crypto sectors, including smart contract platforms, privacy coins, stablecoins, and utility tokens, to diversify within the cryptocurrency market. (Note that these may not be available on M1 at this time.) 
• Consider different investment strategies within crypto, such as trading, holding, staking, or participating in decentralized finance (DeFi) projects, to potentially diversify your approach to digital assets. 

Diversification within Real Estate 

• Investing in different types of real estate, such as residential properties, commercial properties, and industrial real estate can potentially diversify your portfolio. 
• Consider real estate investment trusts (REITs) focused on specific sectors like healthcare, retail, or residential to diversify within the real estate market. 

Diversification within Commodities

• Consider spreading your commodity investments across various categories, including energy, metals, and agricultural products. 
• Explore commodities with different supply-demand dynamics to minimize exposure to a single commodity’s price fluctuations. 

Diversification within Cash

• Potentially diversify within cash and cash equivalents by holding a mix of short-term Treasury bills, certificates of deposit (CDs), and money market instruments. 
• Consider diversifying your cash holdings across different currencies to manage currency risk if you have international financial interests. 

The M1 line

Diversification can be a key strategy for managing risk and optimizing your investments. 

M1 provides the tools you need to build and maintain a well-diversified portfolio. 

Remember that diversification is not a one-time task; it requires ongoing monitoring and periodic rebalancing to keep your portfolio aligned with your goals. By diversifying both by asset class and within asset classes, you can create a robust investment strategy that positions you for long-term success.

DISCLOSURES:

All investing involves risk, including the risk of losing the money you invest. Brokerage products and services are offered by M1 Finance LLC, Member FINRA / SIPC, and a wholly owned subsidiary of M1 Holdings, Inc. 

M1 does not provide investment advice, and this is not an offer or solicitation of an offer, or advice to buy or sell any security, and you are encouraged to consult your personal investment, legal, and tax advisors. Past performance does not guarantee future performance. 

Investing in cryptocurrency comes with significant risk and may not be suitable for everyone. Based on your specific situation and financial condition, carefully consider whether investing in cryptocurrencies is suitable for you. For relevant disclosures and risks, visit Crypto Disclosures. 

Crypto services, execution, and custody are provided by Bakkt Crypto Solutions LLC (NMLS ID 1828849) through a software licensing agreement with M1 Digital LLC. Bakkt Crypto Solutions LLC and M1 Digital LLC are not registered broker-dealers or FINRA members and your crypto holdings are not securities and are not FDIC or SIPC insured. 

M1 Digital LLC is a wholly separate affiliate of M1 Finance LLC, and neither are involved with the execution or custody of cryptocurrencies.

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