How to Diversify Your Portfolio the Right Way
The world of investment is complicated. Whether you are a novice or seasoned investor, the financial world can be intimidating. However, the ultimate key to successful investing is diversification. Diversification is an effective portfolio management strategy where your funds are invested across different securities to minimize risk and maximize profits in the long term. The governing principle behind diversification is to avoid putting all your eggs in one basket.
Diversification is a recommended investment strategy to manage investment risk. It allows you to allocate your investment funds strategically across different assets and sub-categories to manage portfolio risk and returns. In simple terms, diversifying your portfolio helps to avoid overly investing in a specific area. So, if a particular investment diminishes in value, you do not lose all your hard-earned money. Most investors are unsure of how to diversify a portfolio. However, there is no standard answer to this, as diversification is a subjective strategy. This means that your perfect balance of assets might not be ideal for another investor’s portfolio. Your diversification strategy will depend on your risk tolerance, life stage, financial goals, and time horizon. Ideally, the most effective way to diversify a portfolio is to understand what portfolio diversity is, why diversification is a recommended investment strategy, and, accordingly choosing the right securities for your portfolio per your financial preferences. If you need help in selecting securities for your investment portfolio, you can reach out a to a professional financial advisor who can advise you on the same based on your risk appetite and present and future financial goals.
Here is what you need to know about the importance of diversifying your investment portfolio:
What is portfolio diversity?
As an investor, there are several things you can do to protect your portfolio against market risk. However, one significant way to protect your portfolio is by diversifying your investment by including different securities from various issuers and industries. You spread your investments so that your exposure to any particular type of asset is limited. This method aims to reduce the market volatility of your portfolio over time. When you invest across different areas, you minimize risk and protect yourself against market volatility. If one investment fails, the remainder of your portfolio can help towards ensuring the portfolio is secure on the whole.
It is important to diversify your investments because a portfolio comprising different assets typically yields higher long-term returns while reducing the risk of any individual holding or security. You can diversify a portfolio in terms of asset classes as well as within these asset classes and geographical boundaries – foreign and domestic markets. The rationale is to use the positive performance of one area to outweigh the negative performance of another. Hence, to achieve portfolio diversification, you invest in more than one type of asset, including bonds, shares, commodities, Real Estate Investment Trusts (REITs), hybrids, exchange-traded funds (ETFs), annuities, foreign stocks, and more.
You can choose different securities within the same asset class to create a diversified portfolio. For instance, multiple bonds from different issuers, stocks of different companies from varied industries, etc. The prime objective is to avoid investing in securities that are highly correlated to each other. When you choose different asset classes and securities, your investments have different lifecycles that help to minimize the impact of any negative situations that could otherwise potentially affect your portfolio. For instance, stocks generally do well when the economy grows. In the desire for higher returns, investors push up the prices of stocks. Alternatively, bonds and similar fixed-income securities perform better when the economy is sluggish.
On the contrary, commodity prices are unrelated to the phases of the business cycles like bonds and stocks. The performance of commodities depends on their supply and demand factors. For instance, wheat prices may rise if there is a drought that potentially reduces the wheat supply in the market.
It is not mandatory to invest in securities that are negatively correlated to each other. The goal of diversification is to invest in assets that are not closely interrelated with each other.
Is it important to diversify your investments?
It is important to diversify your investments to minimize your investment risk, and to some extent, potentially increase your returns. Most investors may not have comprehensive knowledge of the market to determine the future. Hence, picking one investment that will perform well for as long as needed is a highly optimistic assumption. Therefore, since the future is unlikely and markets are changing, diversifying your investments across different assets, asset classes, companies, and geographies is a fruitful investment strategy.
The objective of diversification is not to maximize returns. In fact, in the short term, investors who concentrate their funds on a limited number of investments might potentially perform better than a diversified investor. However, a diversified portfolio can likely outperform a focused portfolio over time.
Typically, the advantages of diversification include:
- Reducing the risk of loss for your investment portfolio
- Opens more opportunities for earning returns
- Shields you against adverse market cycles and phases
- Reduces portfolio volatility
The importance of portfolio diversification is better explained through a recent analysis which found that a simple mix of investments, such as 55% in domestic U.S. stocks, 30% in bonds, 10% in foreign stocks, and 5% elsewhere, could have caused an average loss of 27% in the global market crash of 2008. However, if this portfolio was optimally diversified to include hedge funds, commodities, international bonds, and REITs, the average loss would be 16% during the 2008 market crash.
How to diversify a portfolio
The best way to diversify a portfolio is to select assets that align with your risk capacity and return expectations. Spreading your money across different assets can help you create an optimally diversified portfolio. You can begin with investments in stocks, bonds, and government securities and further diversify into areas like foreign markets, commodities, real estate, etc.
Here are some strategies that can guide you on how to diversify your portfolio:
Create a portfolio with different investments:
Diversification works on the concept of distributing your investment dollars across asset classes, such as stocks, bonds, cash real estate, commodities, etc. You can start by investing in stocks, bonds, and other similar fixed-income securities. Once you gain the confidence and market knowledge, you can diversify across broader asset classes like commodities, alternative assets, etc. The objective is to divide money effectively to balance risk and return. For instance, stocks are high-risk, high-rewarding investments, but bonds are more stable and less-risky investments. To minimize risk, you can create a balance of stocks and bonds in your portfolio. Typically, the ideal allocation of assets in your portfolio depends on your age and lifestyle. At a younger age, you can afford to invest in riskier asset classes like stocks, real estate, commodities, etc. However, if you are closer to your retirement, you can opt for conservative asset options like bonds, government securities, cash deposits, and more. If you find balancing stocks, bonds, and other assets difficult, you can invest in safer and already diversified asset options like ETFs, mutual funds, index funds, and more. ETFs and mutual funds contain a basket of stocks, allowing instant diversification of your portfolio. Index funds include stocks that mirror a specific index, such as S&P 500. Ideally, a well-diversified portfolio should comprise stocks, bonds, cash, alternative assets, ETFs, and mutual funds. It is also beneficial to invest some portion of your funds in life insurance and other similar assets. Irrespective of which asset classes you choose, it is wise to pick investments after considerable research. For instance, it may not be advisable to randomly invest in high-performing stocks. Instead, spend time to gain a deep understanding of the companies you want to invest in. Assess their fundamentals, operational procedures, management changes, financial soundness, industry standing, and more. Aim to absorb as much information as possible before you diversify.
Diversify within asset classes to minimize risk:
Diversification is not limited to choosing different securities for your investment portfolio. You can diversify funds within asset classes. For instance, when investing in stocks, focus on picking stocks of companies with different market capitalization and sectors. For instance, you can invest in some mid-cap and small-cap companies from the technology, pharmaceutical, and entertainment industry to create a basket of diversified stock investments. You can also diversify across geographies (domestic or international stocks). Alternatively, for bonds, you can consider investing in government bonds, corporate debt instruments, and other fixed-income securities with different credit qualities, return rates, and maturities. In terms of cash, split your money into money market instruments, commercial paper (CPs), T-bills, savings deposits, fixed deposits, etc. In alternative assets, invest a handful of your money in commodities, some in REITs, and if possible, consider buying a home in the long term.
Follow a buy-hold investment strategy:
When investing, it is beneficial to stay vested for a long duration. Think long-term and diversify to avoid knee-jerk reactions. You can consider using the buy-hold strategy to achieve long-term investment goals with an optimally diversified portfolio. This strategy requires you to create a relatively stable portfolio over time, irrespective of the market fluctuations. The idea is not to trade constantly. Instead, adopt a more passive investment approach, giving your investments ample time to grow. However, even in a buy-hold strategy, you can look out to curtail assets that have appreciated too quickly or taken up more than the required allocation on your ideally diversified portfolio.
Choose investments with different rates of return:
When diversifying your investment portfolio, focus on asset categories and subclasses. Also, be careful about picking investments that have varied rates of return. Investments with different return rates can help you balance risk and reward eventually. High gains for certain assets could potentially offset the loss of other investments. For instance, if you invest in stocks, you may choose blue-chip company stocks that offer almost guaranteed but low returns. Simultaneously, invest in stocks of small-cap companies that offer high returns but carry high risk. This strategy allows you to counterbalance the high returns from small-cap company stocks with low-risk, blue-chip stocks. Alternatively, if small-cap stocks underperform or suffer a loss, assured returns from blue-chip stocks can help balance the portfolio returns. Alternatively, you can consider investing in foreign stocks to diversify investments across varied returns. Foreign stocks perform slightly differently and balance out an otherwise domestic-heavy investment portfolio.
Rebalance your portfolio at set allocation points:
Diversification is not a one-time strategy. It is a process. Hence, it is important to check your investment portfolio often and make alterations accordingly to ensure the risk level aligns with your financial goals or strategy. Review your portfolio vis-a-vis your goals and life milestones coupled with where you began from and how far you have reached. For instance, you are unmarried with fewer financial responsibilities, and hence, you created a stock-heavy portfolio since your risk tolerance was high. However, in the following year, you got married, your financial responsibilities increased. You now want to invest in a home and create a fund to manage your increased expenses. In this case, you want a source of fixed income rather than volatile returns from stocks. You can rebalance your portfolio to sell some stock holdings and reinvest the sum into fixed-income, less volatile securities for the long term. If you are unsure about your changing risk levels, you can consult a professional financial advisor to seek guidance on creating an optimally diversified portfolio. The advisor might also review your portfolio timely and ensure it aligns with your lifestyle, life stage, risk tolerance, and investment horizon.
There is no standard diversification strategy as your portfolio composition depends on your risk profile, life stage, financial goals, and investment horizon. However, you can use the above-mentioned strategies to create a framework for an optimally diversified portfolio. But one of the best ways to diversify a portfolio is by researching the market, understanding the securities you want to invest in, and investing per your risk-return preferences. It is also crucial to continuously rebalance your portfolio to relocate funds from assets that have outgrown their optimal allocation or others that are underperforming. It can be beneficial to seek guidance from a professional financial advisor to create a diversified portfolio optimized for risk and return.
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