Most people would rather save their money in a bank somewhere than invest, mainly because of the risks associated with investing. I used to dread the thought of risking my hard-earned money until I understood one of the most basic and effective risk management techniques—diversification.
You’ve probably heard of the term diversification. In finance, diversification refers to the process of assigning capital in a manner that decreases exposure to risk.
The rationale behind diversification is simple—on average, investment portfolios composed of different kinds of investments yield higher returns and pose a lower risk compared to any individual investment within the portfolio. In this article, I’ll cover how to and why you should be diversifying your investment portfolio.
How to diversify your portfolio
Here are four steps you can take to start bringing more diversity to your portfolio:
Step 1: Ensure your portfolio has many different investments
ETFs & mutual funds
An effortless way to do this is by purchasing ETFs, index funds, or mutual funds. ETFs and mutual funds act as a basket of different stocks—giving you instant diversification. They trade differently, so you’ll want to read about each in detail before buying them, but they’re an excellent method to diversify without getting overly complicated.
Index funds are another excellent option—as they include stocks that mirror a specific index—such as the S&P 500. Your diversification may be a little more limited here, but it’s still a sound option to consider.
A properly diversified investment portfolio should include:
Step 2: Diversify within individual types of investments
Pick investments with different rates of returns
This becomes more challenging when you’re buying individual stocks since you’ll want to invest a decent amount to make the cost of trading worth it. For example, you don’t want to spend $10 to buy one share of stock for $200. You should invest a more substantial chunk, so you save money on fees. Because of this, many people end up with a handful of stocks in their portfolio, putting them at risk.
So when investing in stocks, for instance, don’t concentrate on a single stock or a few stocks but rather, different stocks in different sectors. It’s also essential to have stocks with mixed-income, growth, market capitalization among other metrics. When investing in things like bonds, consider bonds with different credit qualities, duration, and maturities.
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Step 3: Consider investments with varying risk
Choose investments with various rates of return
When diversifying your portfolio, pick different investments whose rate of return is different to ensure substantial gains for certain investments offset losses in other investments.
Remember, although the intention is to minimize risk, you aren’t restricted to blue-chip stocks only.
A good methodology to use here is to look at foreign stocks. Stocks from other countries tend to perform a little differently and typically balance out a domestic-heavy investment portfolio nicely. You can also look at small-cap or mid-cap stocks, which are younger, and more volatile stocks.
Step 4: Rebalance your portfolio regularly
Contrary to popular belief, diversification isn’t a one-time task. You should check your portfolio often and make changes accordingly when the risk level isn’t consistent with your financial goals or strategy. I recommend rebalancing your portfolio at least two times per year. Or, you could use a service like Blooom, which is a 401(k) optimization tool that will make sure your 401(k) is always working for you.
Use a robo-advisor
In addition, if you don’t want to spend the time going in and buying and selling stocks to balance out your portfolio so frequently, I would highly recommend looking into a roboadvisor such as Betterment, which will automatically rebalance your portfolio for you and keep you optimally-diversified.
What should be in your portfolio?
A diversified portfolio should include:
Buying stocks gives you an opportunity to own a percentage of a company which comes with benefits such as dividend payouts and capital gains when the stock increases in price over time. Domestic stocks should be a significant part of your investment portfolio provided they offer great opportunities for growth in the long-term.
The world’s greatest investor, Warren Buffet shows us exactly how to diversify when investing in domestic stocks with his top five stock picks being Apple, Wells Fargo, Kraft Heinz Company, BoA (Bank of America) and Coca-Cola. The stocks represent different companies in different sectors.
Bonds offer regular interest income. They are less volatile than stocks making them a good “cushion” during unpredictable movements in the stock markets.
Stocks should be a significant portion of a portfolio for an investor focused more on the safety of their investment than growth. It is worth noting that bonds don’t offer higher returns than stocks in the long term, in most cases. However, there are certain international bonds which provide higher yields.
If you’re looking to get into bonds, there’s a very cool company called Worthy that’s offering a fixed 5% annual interest rate – and each bond costs just $10. We’re pretty impressed with what they’ve been doing so far in the bond space.
Your portfolio should also include short-term certificates of deposits as well as money market funds which offer stability as well as easy access to investments. Investments such as certificates of deposits are insured/guaranteed by the FDIC making them safer; however, they aren’t as liquid as money market funds.
A good mix of international stocks is recommended to protect your portfolio against the local stock market “shocks.” Stocks issued by US companies perform differently from those issued by non-US companies since they have exposure to different opportunities in other parts of the world.
As the name suggests, sector funds are investment funds which focus on specific sectors/segments of the economy. Having sector funds as part of your portfolio offers you unique investment opportunities in different economic cycles.
Real estate fund
Investment portfolios with real estate funds which include real estate investment trusts offer protection against inflation. The funds also provide unique opportunities in real estate you wouldn’t otherwise be able to take advantage of on your own.
Equity funds which focus on commodities such as gas, minerals, oil, etc. can protect your portfolio against inflation. The funds also shield investors from the risks associated with commodities since commodity investing is recommendable for seasoned investors only.
Asset allocation funds
Asset allocation funds come highly recommended if you are keen on diversifying, but you don’t have the expertise and/or time to build a diversified portfolio yourself.
Why you need to diversify your portfolio
Diversifying reduces the uncertainty of investing
There is a level of uncertainty in every financial market. If you put all your money in stocks, you risk losing everything if the stock market crashes. The same applies to the real estate market, commodities markets, currencies, and any other investment. However, all markets hardly crash at the same time, in the same manner.
The same applies to investments in the same asset class. For instance, two stocks of different companies in different sectors fluctuate differently. By diversifying, which is just putting your money in various investments across different sectors, the probability of losing a significant amount of money or your entire investment is very low.
An example of diversification
A simple mix of investments—55 percent U.S. stocks, 30 percent U.S. bonds, 10 percent foreign stocks (from developed countries) and 5 percent stocks—would have resulted in an average loss of 27 percent during the 2008 crash according to global investment research firm Morningstar.
So by “putting all your eggs in one basket,” you’re actually hurting yourself financially. Diversification will reduce risks and make your returns more stable over the long-term. But it doesn’t have to be complicated.
Warren Buffet has been on record stating that diversification is “protection against ignorance” making it unnecessary when you know precisely what you are doing. However, Buffet is already a seasoned wealthy investor. He has spent decades mastering the game of investing and is now equipped with investing resources and experience beyond the reach of ordinary investors.
I suggest ignoring this piece of Buffet’s advice until you become accustomed to investing.
When starting out, I encourage diversification especially if you are like most people (i.e., you are looking for better alternatives to saving money in the bank while still protecting your capital).