As the famous adage goes, it’s not smart to put all your eggs in one basket. When it comes to investments, diversifying is one of the smartest things you can do. It can help protect you against certain effects that may affect your investment. Let us look at an industry-specific risk, often found in energy stocks as an example. If the price of oil goes down, it almost always affects every company that works in oil and gas, pulling their share prices in a downward trend. If you were smart enough and invested in other industries that aren’t energy-specific, then the value of your total investment will feel less of an effect than otherwise.
Diversification doesn’t completely protect you from losses, neither does it guarantee returns. Systematic risks, for instance, including interest rates, geopolitical events and inflation can lead to instability in the entire market, and thus affecting your entire portfolio in stocks, regardless of the industry.
That being said, here are some expert tips on how to diversify your portfolio:
Determine Correlation
It is imperative to determine the correlation between your investments. Even if you have multiple investments, if they go up or down together, then your portfolio is not really diversified. For instance, high yield bonds tend to have a positive correlation and so, having a portfolio entirely made up of the two isn’t properly diversified.
Diversify Within Asset Classes
Here are a few ways to diversify within asset classes.
(i) Industry- For instance, if you invest in energy stocks, you may want to look into utility, biotechnology, technology, retail and similar classes, it is wise to also invest in smaller companies
(ii) Funds- While index funds track the overall market, some funds focus on specific sectors. So, if your goal is to diversify, you’ll want to check what stocks the funds go into to ensure you are not overly exposed to one segment or another
(iii) Bonds or Fixed Income Assets– Look into bonds with varying maturity dates and from different providers, including corporations and the government.
Diversify Across Asset Classes
There are various asset classes to pick from. These include:
-Bonds or fixed-income investments
-Equities or stocks
-Real assets such as commodities and property
-Cash and cash equivalents
These classes have different levels of risk and returns and so, investing across these asset classes will help create a truly diverse portfolio.
Diversify by Location
In addition to asset classes, you can also choose to diversify your investment portfolio by location or global exposure. For instance, if you only own U.S securities, then your entire portfolio is subject to the country’s specific risk. Bonds and stocks from other countries can help diversify your portfolio further. However, keep in mind that this comes with foreign-specific risks like currency risks, foreign taxation, and risks related to economic and political development.
Determine Your Risk Tolerance
Your risk tolerance can have an effect on your approach to portfolio diversification. In general, the longer the timeframe, the more you can capture long-term gains and weather short-term losses.
Generally, aggressive investors have a time horizon of at least 30 years. This flexibility exposes them to higher risk tolerance and can therefore allocate 90% of their investment in stocks and 10% in bonds
For investors with a 20-year timeframe, allocating a lower percentage of money to stocks, usually, 70% and the rest in bonds is the general rule of thumb
If you are a conservative investor with a low-risk tolerance or need your money in 10 years or lower, then it’s best to do a 50-50 balance between bonds and stocks.
Explore Alternative Investments
If you want additional diversification, you may want to look into commodities and REITs or Real Estate Investment Trusts. The latter owns and runs properties like apartment buildings, apartment buildings, and shopping centers. Owning shares in these gives you the opportunity to receive part of these businesses’ earnings in the form of dividends. In addition, REITs aren’t strongly connected to bonds or stocks.
Commodities are simply investments in physical goods, examples being wheat, gold, natural gas, etc. You can purchase them directly or via a commodity fund.
Rebalance the Portfolio Regularly
Even with a properly diversified portfolio, it is important to rebalance it on a regular basis. Over time, some investments will lose value, while others will increase in value. Rebalancing helps negotiate between risk and reward, which protects your portfolio during market highs or lows.