Understanding portfolio diversification is the first step to creating a well-rounded portfolio. Regardless of your age or how long you’ve been investing, diversification is an essential part of every financial plan.
According to Investopedia, “Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. “
The future is uncertain, and that’s why having multiple income streams towards different goals can be beneficial over time. Even if one area experiences short-term problems, then another area still might help you make up for it in the long run. A very basic diversification plan involves dividing your investment portfolio into a Stock and bond portion since they tend to move in opposite directions. To further diversify you can add a gold, precious metals, or real estate portion.
To get the best diversification you want the various sectors of your portfolio to have very little correlation with each other so when one is moving down another sector will be moving up. You can look up the correlation coefficients of various investments to determine how well they balance each other. A negative correlation means that when one rises the other falls but it is rare to be able to find a 100% negative (or inverse) correlation. Often you will find a low correlation of perhaps 30% or even zero correlation meaning that they just travel totally independently.
Here are eight tips to help you better understand portfolio diversification:
1. Don’t Put All Your Eggs in One Basket
This is the most basic rule of investing, and it still applies today. You never want to have all of your money invested in just one security or asset class. This leaves you open to many risks if that particular investment falls in value. The easiest way to do this is to buy an index fund that mimics something like the NYSE or S&P500.
2. Diversify by Asset Class
There are different types of assets that you can invest in stocks, bonds, commodities, and Real Estate. To diversify among different real estate investments beginners might choose a REIT (Real Estate Investment Trust) which is basically a mutual fund for real estate.
Other more advanced options include: A Delaware Statutory Trust, referred to as a DST, it is “an effective and judicially secure legal entity that allows investors to participate in potentially higher-grade real estate investments they otherwise might not be able to afford”. If you are interested in a DST, consider checking out options like DST properties for sale.
3. Diversify by Company Size
It would help if you also diversify your investments by company size. Investing in small-cap companies comes with more risk than investing in larger companies. Small-cap companies tend to be more volatile than larger-cap companies and so might do better in an up-trend but much worse in a downtrend. By adding an index fund that tracks the NASDAQ to your portfolio you can get an extra boost during up markets.
4. Diversify by Industry or Sector
You can also diversify by industry or sector. For example, you could own both financial and healthcare stocks rather than only one of those types of securities. Alternatively, you could own Airline and Oil company stocks. Oil stocks do well with rising energy costs while airlines do better when energy costs are falling.
5. Don’t Forget about Geographical Diversification
Try not to ignore geographical diversification either. Owning companies in the same geographical region can expose your portfolio to certain risks that you might not be able to diversify away. For example, if most of your investments are in the U.S., then you’re more exposed to economic problems here than if some of your money was invested overseas. There are a variety of different mutual funds for Emerging Markets, Pacific / Asian market funds, European Funds, Latin American Funds, etc.
6. Diversification is a Balancing Act
Every investor has different goals and risk tolerances when it comes to diversification. This means that there isn’t one specific plan for everyone – all investors have their unique situation, which requires their unique strategy. The more time you spend developing an understanding of financial markets, the better you will get at deciding what asset mixes work best for your specific needs.
7. Know How Much Risk You Can Handle
Before making investment decisions, you have to know how much risk you can handle. If your goals are long-term, then it’s probably OKay to take a bit more risk with your investments hoping for a higher return. Plus, you will have time for your investments to bounce back from downturns. However, if you’re investing money that needs to be used soon or for a shorter-term goal, then taking less risk is appropriate because you won’t have the time for it to bounce back.
8. Diversification isn’t Just About Buying Different Securities
A more sophisticated way to diversity is by using options strategies. For example, selling call options against shares you own can generate cash flow and reduce the cost basis on stock positions in your portfolio. This strategy works well when you own low volatility stocks because if they don’t move up you get to keep the option premium and your stocks. Buying put options can protect you against large drops in stock price but cost you money in the short run, much like an insurance policy.
Also, keep in mind that diversification doesn’t mean buying different securities. You could also achieve diversification by investing in a mutual fund or ETF. These types of investments offer instant diversification across many companies, sectors, and asset classes.
When it comes to your investment portfolio, it’s always important to remember the adage: don’t put all your eggs in one basket. This is especially true for something as important as your retirement savings. Diversification is one of the most important concepts in investing, and it’s something that all investors should be familiar with.
Conclusion
In conclusion, there are a few different ways to diversify your investments. You can diversify by asset class, company size, industry, and sector. You can also diversify by geographical region, and you should know how much risk you’re comfortable taking on. Finally, remember that diversification doesn’t just mean buying different securities – you can also achieve it through options strategies or investing in mutual funds or ETFs.
You might also like:
- What is the Real Inflation-Adjusted Stock Price?
- Treasury Inflation-Protected Securities (TIPS)
- Gold as an Investment
- What Do Correlation Coefficients Positive, Negative, and Zero Mean?
- How to Calculate the Beta of a Stock
- Diversification: The Simple Secret to Building Your Wealth
- Should Investors Diversify Using Inflation-Protected Annuities?
