Portfolio diversification is the most basic and effective way of minimizing risks in the financial markets. Diversification is the art of spreading ones capital by investing in different securities, as a way of ensuring exposure to one type of asset is limited. The practice goes a long way in reducing the volatility of your portfolio over time.
A diversified portfolio will always consist of different types of financial instruments touching on various industries or sectors. While diversification does not guarantee protection against risks, it goes a long way in ensuring one achieves financial goals with ease.
Read on, as we cover the steps and investments in achieving a diversified portfolio.
Components of a Diversified Portfolio
Stocks account for the most significant chunk of most diversified investment portfolios. It is because they provide opportunities for higher growth over a long period. However, short-term investors reduce their exposure to stocks, as they are generally more volatile than other securities. While volatility is a good thing, it can also work against you, especially in times of a downturn.
Read: The Complete Beginner’s Guide to Investments
Bonds are also an essential ingredient of a diversified portfolio. For income-focused investors then this is the way to go, given that bonds provide regular interest income. Bonds also act as a cushion against the difficulties that often rock the markets.
Investors focused on safety rather than growth should find comfort in U.S Treasury or high-quality bonds. High-quality bonds are ideal for investors who are willing to contend with lower long-term returns.
Short Term investments also provide an ideal way of diversifying an investment portfolio. Such investments include money market funds, which are conservative investments designed to offer stability and easy access to money. Given that they are ideal for preserving capital, they tend to provide lower returns than bond funds.
Certificates of Deposit though devoid of the liquidity offered by Money Funds tend to be much safer as the Federal Deposit Insurance Corporation guarantees them.
Sector funds are securities that invest in a wide array of stocks. However, they focus on a particular segment of the economy thereby providing exposure to a diverse range of shares in the given sector. Sector funds are ideal diversification assets as they allow investors to enjoy opportunities in different phases of economic cycles.
Experienced investors many at times add commodities in their investment portfolio by investing in commodity funds. Such funds provide exposure to items such as oil, gas among other natural resources traded in the financial market. Such assets act as a good hedge against inflation.
Real Estate Funds
Commonly referred to as Real Estate Investment Trusts, REITs tend to expand an investment portfolio exposure into the real estate sector. Such funds invest solely in stocks of companies with operations in the real estate sector. Such securities also provide some level of protection against the risk of inflation.
Read: Investing in Real Estate vs Stock Market: Pros & Cons of Each
When it comes to asset allocation in portfolio diversification, there are no clear-cut rules. Instead, any distribution should be based on one’s needs as well as investment strategy. Below are some of the things to keep in mind when allocating assets in a portfolio in the effort of diversification.
Current Asset Allocation
When it comes to portfolio diversification, the idea is to spread the risk and exposure to unrelated financial instruments. In this case, investing only in stocks would not cut it. Instead, one should strive to invest in varying assets such as bonds ETFs, REITs as well as commodities.
Such a play would allow one to navigate various economic cycles that affect securities at different times and with a different outcome. Most investors lean more toward domestic equities and debt. However, that should never be the case, given the vast array of asset classes available.
Consider Debt Products
While debt products do offer lower returns, one cannot ignore them altogether. Any investment strategy should strive to create a liquid corpus that can accommodate expenses. In this case, one should consider investing in liquid instruments where buying and selling is much more comfortable.
Liquid assets can be broken much easier thus allowing one to gain access to much-needed cash in times of emergencies
Consider Your Age
When it comes to portfolio diversification, investors’ age is a significant consideration. The commonly used thumb rule for asset allocation is 100 minus one’s age. In this case, young investors between 25 and 35 years should strive to have a higher equity allocation of between 65% and 75%. Older people, on the other hand, should have a lower equity allocation.
Young investors have the benefit of a long investing career thus can wait much longer in case their portfolio takes a tumble. Unlike the older folks, young investors don’t have to contend with too many financial obligations thus can take higher risks.
Willingness and Ability to Take Risks
When it comes to portfolio diversification, one must be able and willing to take risks. Equity allocation can only be right when one takes 20-30% cut without losing sleep over their capital. Given that risk appetite is a double-edged sword, investors also ought to take risks, only when they understand the implications involved.
People with steady income streams to supplement the investment adventure can take higher risks. It is because market volatility would most of the time not affect their lifestyles. For investors relying on investment returns to support their livelihood, then taking calculated risks is necessary.
The time available to achieve a given goal when investing is essential. Invest in equities only when you are doing it for the long haul. Interestingly, invest in debt for the short term.
A thumb rule in diversification is that one should never invest in equities if the holding period is less than three years as the returns will not be as lucrative as expected. In case you are investing for the long term, then investing more in equities would be the right call.
Asset location should never ignore market situations or economic cycles. For that reason, it is essential to tweak an investment portfolio from time to time, all in the effort of enjoying maximum returns depending on the market cycle.
When it comes to tweaking an investment portfolio, investors should always, reduce their allocations to equities whenever the PE of benchmark indices jumps above 24 and whenever it drops below 16.
Don’t Over Diversify
Contrary to perception, greater diversification is not always a good thing. A well-diversified investment portfolio should not contain more than 20 securities, especially in the equity markets. It is because diversification can only reduce risks to a given level.
Over-diversification increases, ones risk exposure beyond market risk something that can be catastrophic in case of a downturn. Over-diversification would also result in one investing in more than one security from a given sector or industry something that would exacerbate the risk exposure. Diversification only reduces the risk but does not obliterate it.
Ways To Diversify an investment portfolio
Portfolio diversification has its intrigues and strategies that vary depending on one’s investment strategy. Spreading an investment portfolio among different investment vehicles is a commonly used diversification strategy
The approach involves including cash, stocks, bonds, mutual funds as well as ETFs in an investment basket. In this case, one can pay attention to assets that have not moved in the same direction to the same degree. Such a play ensures that’ whenever one asset is on a downward trajectory its losses are offset by assets on an upward trajectory.
Read: What is an ETF? The Complete Beginner’s Guide to ETFs
The second strategy involves staying diversified within each type of investment. An investor, in this case, can include securities that vary by sector, the industry as well as a region or market capitalization. The idea is to invest in securities that differ when it comes to growth metrics, income generated or value.
Investing in securities that vary when it comes to risk is another effective investment diversification strategy. Instead of focusing on a given set of equities such as blue-chip stocks or retail stocks, one can go for stocks or securities with different rates of returns. Varying rates of returns ensure that whenever one asset is on a downtrend those on an uptrend offset its losses.
Professional investors make significant returns on understanding the fact that portfolio diversification is not a onetime task. In this case, they carry out checkups and rebalancing from time to time. The rebalancing act ensures that the risk an investment portfolio carries is consistent with financial goals and strategy.
Investment Portfolio Diversification Tips
No matter how exciting and enticing securities look, never put all your money in one stock or one sector. The basic principle of diversification is spreading capital to an array of securities. Strive to create a virtual mutual fund by investing in a handful of stocks, bonds, metals, ETFs etc.
Invest in Index or bond funds, In addition to investing in stocks, currencies as well as metals. The thing with investing in securities that track various indexes is that they provide greater diversification. Such indexes consist of stocks from different sectors useful for spreading one’s exposure.
Investing in fixed income solutions also goes a long way in hedging one’s portfolio against market volatility as well as uncertainty. The strategy goes a long way in reducing one’s risks as well as losses in case of a downturn.
Grow Your Portfolio
Adding investments to a portfolio on a regular basis should always supplement any diversification strategy. While leveraging the dollar cost averaging strategy, you can invest money on a regular basis into various securities as part of the strategy
While diversifying a portfolio, it is also important to know when to get out. Professional investors stay current with their investments and stay abreast with changes that make the markets move. In this case, adjustments should always come into play to trim where necessary and add where needed as well
Benefits of Investment Portfolio Diversification
The primary goal of diversification is not just to boost performance but to provide the potential to generate significant returns at a given level of risk.
Risk management is one of the attributes and benefits that come with portfolio diversification. Diversification lowers the volatility of a portfolio as not all assets move in the same direction. Investing in a variety of non-correlated assets also eliminates unsystematic risk.
Investing in a variety of non-correlated assets can also reduce the number of losses accrued in a bear market. Whenever one security in a portfolio is accruing losses, then other non-correlated assets accruing profits would be able to offset its losses.
Proper diversification is an effective way of achieving portfolio optimization. Managers, in this case, invest in a higher number of risk assets while averting the possibility of taking in more risk than planned from one single asset.
Diversification makes it much easier to protect capital while allocating money to different investments. The investment strategy allows one to invest in a variety of assets thus reduce the risks involved significantly.
Diversification enables one’s investment portfolio to continue growing when markets are booming and when there is a downturn. An investor, in this case, can achieve positive returns in one market depending on securities invested, even as another market continues to generate negative returns.
Diversification offers a good number of benefits to investors who know what they are doing. For starters, it is averse for risk and works for prudent investors. Besides, it protects capital from wild swings of the market, ideal for achieving long-term growth.
However, diversification cannot prevent one from losing money in the market. Instead, it only reduces the risk exposure. When it comes to portfolio diversification, an investor should always keep in mind the risk they are prepared to accept on invested capital.
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