The logic is quite simple – do not put all your eggs in one basket.
This applies to your investments as well. In order to restrict the damage to your financial well-being, it is important to manage the risks you are exposed to. Everyone wants to make the most of their investment portfolio, so whether it’s stock, commodities, ETFs and mutual funds or even the equity within your real estate, a diversified portfolio minimises risks while investing.
However, is diversifying your portfolio as simple as spreading your assets around?
Here is a look at some of the top strategies for diversifying your investment portfolio the right way.
Contents:
- What is Portfolio Diversification?
- Why Portfolio Diversification is So Important?
- Define Your Goals
- Strategies for Diversifying Your Portfolio
What is Portfolio Diversification?
Portfolio diversification is dividing an investment portfolio among different asset categories - stocks, commodities, ETFs and mutual funds, bonds, cryptocurrencies, and cash, etc. This is to reduce the investor's overall risk profile. This could also include owning stocks from several different sectors (tech stocks, energy stocks, and healthcare stocks), market capitalization (large-cap stocks, small-cap stocks, dividend stocks, growth stocks, and value stocks), geography, company sizes, volatilities and risk profiles, as well as other investments such as bonds, commodities, and real estate.
Asset allocation reduces your risk of a permanent loss of capital and, in turn, has the potential to improve returns. However, the returns from a diversified portfolio tend to be lower than what an investor might earn if they are able to pick a single winning stock.
Why Portfolio Diversification is so Important?
Having a mix of different asset types with investment returns that move up and down under different market conditions can protect an investor against significant losses. If you take a look at market history, you will realise that factors that cause one asset category to go up causes another one to have low returns. By spreading your capital across different asset categories, the risk of losing your money is reduced. If one asset category’s investment fails, you can stabilise your losses with better investment returns in another one.
Portfolio diversification is significant because it has an impact on your financial goal. Money invested for short term goals should be invested differently than funds reserved for long term goals. For instance, if you are investing for a long term goal, such as retirement or college, you need to include stock or stock mutual funds in your portfolio. On the other hand, if you include too much risk in your portfolio, the funds reserved for short term goals, such as saving for a birthday gift, may not be there when you need it.
Check Out: Best Long-Term Investments
Define Your Goals
Are you saving up for a house? Or planning to save for an emergency medical fund? Or need to know about the best investment portfolio for retirement?
Whether you are a beginner or veteran in investments, defining your goal is an important step to successful stock market investing. For a long-term investment plan, you could invest in a more volatile, investment, but for an investor saving up for a teenager’s college education would likely take on less risk.
Strategies for Diversifying Your Portfolio
It is easy to make mistakes while diversifying your portfolio. As an investor, this can cost you your hard-earned money while also reducing the actual amount of diversification you have in your portfolio.
Here are a few tips you can take to start bringing more diversity to your portfolio.
Choose a range of assets
For a more tailored investment portfolio, find equilibrium between risk and surety – so never put all of your money into one stock or one sector. This is because the values of different assets can move independently and often for different reasons and a diversified portfolio gives you more exposure to higher returns.
While the performance of a share is influenced by how a company performs and its prospects, bonds and real estate are influenced by interest rates, the latter is more affected by economy as well.
So, ensure your portfolio has many different investments. A balanced investment portfolio should include the following investment choices:
- Cash: These include savings deposits, certificates of deposit, treasury bills, money market deposit accounts, and money market funds. The safest of investments, but offer the lowest return.
- Stocks: A type of security that gives stockholders a share of ownership; the greatest risk and highest returns.
- Bonds: Also known as fixed income securities, bonds are less volatile and offer modest returns, but can vary as interest rates rise and fall.
- ETFs: Exchange-traded funds are an index of securities that trade on an exchange.
- REITs: Real estate investment trusts owns, operates and finances income-generating real estate.
- Mutual funds: One of the most popular investment options, MFs pools money from investors and invests the money in securities like money market funds, bond funds, stock funds, and target date funds.
However, while investing in a mix of assets can be a good strategy, make sure that you have a manageable portfolio. You would not want to invest in a range of assets and not have the time or resources to keep up.
Diversify within individual types of investments
One of the smartest ways to build a diversified portfolio is to invest within individual types of investments.
If it is stocks you are looking at, go for at least 10 to 15 different companies from a variety of industries and sectors. For instance, you have decided to invest in a number well-known Automobiles majors. What happens if the Automobiles sector takes a hit due to the weak economic scenario, new government regulations, or like what happened after the outbreak of Covid-19? You could be majorly hit and for the same reason, you should make sure you spread your investment around several industries.
Investing in a wide range of companies and industry sectors is an excellent option, but the whole process can be challenging if you are a beginner. You could diversify your portfolio within each asset category through managed funds rather than through individual investments from each asset category.
A mutual fund is a managed funds company that pools money from many investors and invests the money in stocks, bonds, and other financial instruments. This best works for beginners and those who do want to own a small portion of many investments but do not have the time to research.
Another managed fund is an index fund. Here, you're buying shares of a single fund that gives you exposure to the largest public US companies.
Diversify within individual types of investments with various risks
When diversifying your portfolio, pick investments with various risks to ensure that the gains for some investments offset losses in other investments.
Time-based diversification
If you thought that diversifying your portfolio is just about investing in different asset classes, you are mistaken. The time when you invest and withdraw funds are just as important. Retirement savers, for example, often plan for long-term investments and seldom go for short-term gains.
Rebalance your portfolio periodically
So, we know that diversifying your portfolio is important; but doing the process once is not enough. You need to review and maintain your portfolio periodically. This needs to be done annually, but preferably quarterly. This helps you keeping tabs on how well your portfolio is performing.
The risk levels of the assets are never consistent and the past performance does not guarantee future results.
These are the three different ways you can rebalance your portfolio:
- Sell off investments from risk-weighted asset categories and use the funds to buy investments for under-weighted asset categories.
- Buy new investments for under-weighted asset categories.
- Change your contributions so that more investments go to under-weighted asset categories until your portfolio is back into balance.
Read Also: 7 Investments That Turned $50,000 Into $1 Million (or More) in 2 Years
Know when to make a move
Just because you have diversified your portfolio does not mean that you can take no notice of what is going on around. Even if you have long-term goals for your investments, there may be times when would need to take a stock of your holdings and whether they make fiscal sense. There are chances that a stock that used to perform well is undervalued or a stock or a mutual fund is underperforming.
You need to be well-informed about your investments and at the same time be aware of all the changes taking place in the market and the factors affecting the market. Study the companies, sectors and industries you are investing in and make yourself familiar enough to make the right decisions. By doing so, you will also be able to tell when it's time to cut your losses, sell and move on to your next investment.
Keep an eye on commissions
If you are a beginner in the world of investments, ask around and get guidance on what you are getting for the fees or commissions you are paying. Some firms charge on a monthly fee, while others charge transactional fees. Keep yourself updated on whether there are any changes to your fees.
Investing properly gives your money the prospect to grow and help you reach your financial goals. Diversification reduces an investor's exposure to a single stock, industry, or investment option.
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