Remember the adage, “Don’t put all your eggs in one basket”? This old saying certainly holds when making investing decisions; in fact, diversification—both between asset classes and within individual asset classes—ranks among the most powerful tools in your arsenal when it comes to reducing avoidable risk. As I’ve talked about before in this column, diversification is critical for any type of investing, in particular alternative investing. Equity crowdfunding is simply a mechanism to facilitate investments into private companies.
Here’s why diversification is so important.
Importance of Diversification
In a nutshell, investment diversification simply means allocating your financial resources across multiple instruments and areas in order to reduce risk. Because these different instruments and areas react differently to events that affect the economy and the market, diversified asset allocation may help protect your portfolio against suffering loss across the board.
Think of it this way: Consider a store that sells both rain boots and flip-flops. Would the shopkeeper expect to sell both of these items at the same time? Probably not—but that’s the point. On sunny days, customers will purchase flip-flops, and on rainy days, there’ll be a run on rain boots. No matter what the weather, the shopkeeper is making money.
This concept applies to investing as well. When implemented effectively within a well-designed portfolio, this risk management technique balances investments across a range of industries and asset classes, including, for example, public equity, debt and private equity
But it doesn’t stop there. A well-balanced portfolio also includes investments across a range of instruments within an asset class—in other words, more than the five to 10 investments that many financial advisors recommend.
These two facets of diversification mitigate the effects of volatility on a portfolio by spreading risk across a wider field. For instance, if you load your portfolio with stocks from one industry, such as banking or technology, an event that tanks those stocks—such as the bursting bubbles we saw over the past decade—will lead to a drop in your portfolio’s value. In contrast, only portions of a portfolio that contain instruments from many classes—stocks, bonds and funds, for example—and across many industries will be affected.
Diversification is based on the principle of correlation, or connections between assets. Correlated assets move together—They’re affected in similar ways by the same market forces—while uncorrelated assets move in different directions.
Correlation is determined using historical return data. It’s expressed as a number from -1 to +1. The higher the correlation, the closer the movements, and vice versa. For instance, stocks with a 0.6 correlation moved in the same direction 60 percent of the time, while stocks with a -0.6 correction moved in opposite directions 60 percent of the time.
As a general rule, lower correlations lead to greater diversification. In theory, this means that combining assets with low correlations in a portfolio tends to lead to greater efficiency—or the same returns with less risk.
While the theory behind diversification isn’t difficult to understand, applying it is a bit more involved. Asset allocation is a personal process that depends on your unique financial situation. Generally, the amount of assets you allocate across categories depends on three factors:
Your time horizon
Your tolerance for risk
Your overall financial goals
Diversification requires investment across asset classes, which include public equity, debt and private equity.
Public equities include securities such as stocks and shares offered by publicly held companies. Then there are the debt instruments that can be purchased through a variety of mechanisms including mutual funds, ETFs (exchange traded funds), municipal bonds, corporate bonds, lifecycle funds and U.S. Treasury securities.
Within each of these asset classes, practice diversification by:
Choosing assets with low correlation
Avoiding overconcentration in any one particular company and industry (no more than 5 percent)
Spreading assets across a range of sectors, geographical regions and capitalizations, (small cap, mid cap and large cap, for example)
Choosing bonds with varied styles, maturity and sensitivity to inflation and interest rates
Choosing funds with varied growth rates, such as aggressive, quality and price
Private equity investing offers another key to diversification. Historically, private equity investments were the sole purvey of uber-wealthy, sophisticated investors with the time and connections necessary to complete the months of networking it took to secure each deal. This exclusive nature means that it was both difficult and time-consuming for individual investors to achieve private market diversification. It is important for investors to remember, however, that private equity is a high-risk, illiquid asset class.
Today, all that is changing; While the minimums at many private equity firms still often range from six to seven figures, equity crowdfunding sites like CircleUp provide an alternative way for investors to easily find and invest in private companies. As an online marketplace that connects accredited investors with private consumer and retail companies, equity crowdfunding allows investors to invest anywhere from a few thousand to hundreds of thousands of dollars in private equity, all while providing greater portfolio diversification.
The benefits of diversification highlight the value that crowdfunding provides investors of today. Ask yourself, where in your portfolio are the young, growing businesses, yet undiscovered and private, but with a documented history of strong growth? And where in your portfolio are businesses that fit this description and are also vetted by professionals? If they are not a part of your portfolio—and you adhere to a belief in the value of diversification—it might be time for you to consider equity crowdfunding.