How to diversify across asset classes: Stocks, bonds, and more

Why diversification across asset classes matters

Building a portfolio that can handle the ups and downs of the market requires more than just picking strong investments. Diversification of investment portfolios across asset classes adds an extra layer of protection.

Here are some key benefits of diversification across assets:

• Balances portfolio risk. Concentrating investments in one asset class amplifies risk, especially when market conditions turn unfavourable. Spreading investments across categories like stocks, bonds, and real estate helps reduce the impact of market volatility.
• Smooths out performance. Different asset classes often experience peaks and dips at varying times. Diversification reduces sharp changes in portfolio value, creating a more consistent growth pattern over the long term.
• Improves adaptability. Economic cycles don't affect all asset classes equally. Holding a variety of assets ensures a portfolio is better positioned to benefit from changing conditions, whether during inflation, growth, or market stagnation.
• Supports varied investment objectives. Diversification of asset portfolio assets makes it easier to align a portfolio with both short- and long-term financial goals by blending assets with differing time horizons and risk profiles.

Examples of asset allocation strategies

Asset allocation strategies can vary depending on an investor's profile. These examples show how portfolios can be structured for different objectives while maintaining diversification across asset classes:

Conservative portfolio

This portfolio prioritises stability and income protection, making it ideal for risk-averse investors or those nearing retirement.

• 20% stocks (diversified across large-cap and dividend-paying companies).
• 50% bonds (emphasising high-quality government and corporate bonds).
• 20% cash equivalents (such as savings accounts or other money market funds for liquidity and capital preservation).
• 10% alternatives (low-volatility real estate or commodities for additional diversification).

Balanced portfolio

A balanced approach provides moderate growth and stability, suiting investors with a medium risk tolerance and a longer investment horizon.

• 40% stocks (a mix of domestic and international equities for growth potential).
• 40% bonds (blending corporate and government bonds for stability and income).
• 10% real estate (via REITs or indirect property investments).
• 10% cash equivalents (instruments like Treasury bills for liquidity).

Growth-focused portfolio

This strategy focuses on maximising long-term returns and suits investors who can tolerate higher levels of risk.

• 60% stocks (focused on growth-oriented sectors and emerging markets).
• 20% bonds (higher-yield or long-duration corporate bonds to supplement returns with modest stability).
• 10% real estate (to hedge against inflation and provide potential income).
• 10% alternatives (including commodities, private equity, or energy assets).

Each of these portfolios demonstrates how diversification across asset classes supports a range of financial goals while balancing growth and risk.

How to build a diversified portfolio across asset classes

Creating a diversified portfolio across assets begins with understanding your financial goals, risk tolerance, and investment horizon. These factors guide how you allocate your assets across different categories to achieve the right balance between growth and stability.

Here is a simple 3-step roadmap:

1. Get clear on your goals and risk tolerance

Start by identifying your financial objectives. Are you aiming for steady income, capital preservation, or long-term growth? Understanding your goals will help you determine how much risk you can afford. For example, a younger investor who is just starting their investor journey might have different goals than someone approaching retirement.

2. Choose asset classes that align with your profile

Different investors have different needs, so the choice of asset classes should reflect your circumstances. As discussed earlier, stocks provide growth potential, bonds offer stability, and real estate or commodities can be hedges against inflation or volatility. Including a mix of these can balance your portfolio through changing market conditions.

3. Allocate percentages strategically

Divide your investments into percentages that suit your goals. For instance:

• Growth-focused portfolio. 60% stocks, 20% bonds, 10% real estate, 10% alternatives.
• Balanced portfolio. 40% stocks, 40% bonds, 10% real estate, 10% cash equivalents.
• Conservative portfolio. 20% stocks, 50% bonds, 20% cash equivalents, 10% alternatives.

How correlation influences asset diversification

The effectiveness of diversification across asset classes depends on how those assets behave relative to one another. Correlation measures the relationship between the price movements of two assets, showing whether they tend to move in the same direction or in opposite directions.

Correlation is expressed as a number between -1.0 and +1.0:

• +1.0. Perfect positive correlation. The assets move in the same direction at the same rate.
• 0. No correlation. The movement of one asset has no impact on the other.
• -1.0. Perfect negative correlation. The assets move in completely opposite directions.

To reduce overall portfolio risk, it's crucial to include assets with low or negative correlation.

Here are common examples of correlation across assets:

• Positive correlation. Stocks within the same industry often move in the same direction due to shared economic drivers. While this can grow potential returns during favourable periods, it also increases risk during downturns.
• Negative correlation. Government bonds typically have an inverse relationship with stocks, offering stability during market declines. However, this negative correlation can weaken during rising interest rate environments.
• Zero or low correlation. Asset classes like real estate or commodities, such as crude oil, generally show weak correlation with equities. This characteristic improves diversification, though correlations may change under specific market conditions.

Challenges and limitations of asset class diversification

While diversification across asset classes reduces risk and enhances portfolio stability, it comes with specific challenges that investors must consider:

Correlation changes over time

Relationships between asset classes are not constant. Stocks and bonds, historically negatively correlated, may align during rising inflation or extreme market stress. Adapting to these changes requires you to monitor your portfolio regularly and make use of tools like rolling correlation analyses.

Systematic risk remains unavoidable

Diversification cannot shield portfolios from global recessions, geopolitical shocks, or widespread market downturns. These risks require complementary strategies, such as hedging or tactical asset allocation, to mitigate their impact.

Over-diversification can dilute returns

Including too many assets or overly similar investments can spread exposure too thin, reducing the portfolio's ability to take advantage of high-performing segments. Striking the right balance is essential if you want to maintain growth potential.

Complexity and costs

Managing a diversified portfolio, especially with alternative investments, can increase transaction fees and administrative complexity. These costs must be weighed against the benefits to prevent them from reducing your overall returns.

Maintaining diversification through rebalancing

Over time, the performance of various asset classes can cause a portfolio to drift away from its original allocation. For example, if stocks experience a strong rally, they may make up a larger percentage of the portfolio than intended, increasing exposure to risk. Rebalancing ensures the portfolio maintains its intended structure and risk profile.

There are several ways to rebalance a portfolio:

• Sell overperforming assets. Use the money from these sales to buy more of the underperforming asset classes and restore the target allocation.
• Direct new contributions. Allocate new investments to underweight asset classes instead of selling existing holdings.
• Adjust dividend or interest payments. Use payouts from investments to boost exposure to asset classes that need rebalancing.

Frequent rebalancing can result in higher transaction fees or tax liabilities, especially in taxable accounts. Investors can reduce these costs by using tax-advantaged accounts for adjustments. Setting clear thresholds, such as rebalancing only when an asset class deviates by, let's say, more than 5%, may also minimise unnecessary trading.

Conclusion: Diversify across asset classes for portfolio resilience

Diversification across asset classes is essential for trying to build a resilient portfolio that balances risk and growth. When you combine different asset categories, such as stocks, bonds, real estate, or commodities, you can reduce the impact of market volatility and achieve more consistent returns over time.

However, diversification is not a set-it-and-forget-it strategy. You must regularly monitor your portfolio to ensure the allocation remains aligned with your financial goals. This involves rebalancing to address changes in asset performance and adapting to evolving market conditions.