An investment diversification strategy ensures you’re not too heavily invested in one asset class, such as stocks or bonds. This reduces your portfolio’s risk and exposure to market downturns. An investment diversification strategy should complement your portfolio’s asset allocation.
If your portfolio is well-managed, you should see a different percentage of stocks, bonds, and other assets. The percentage of your investment portfolio that’s invested in these assets is called your asset allocation. Depending on your age, risk-tolerance, and other financial factors, your asset allocation will vary. Any savvy investor will tell you that you want your portfolio to be well-diversified within each asset class.
Wondering how to diversify your stock portfolio? Or why should you diversify your portfolio? We’ll go over everything you’ll need to know about rebalancing your portfolio so you can get the most out of your investments.
Why Should You Diversify Your Portfolio?
An investment diversification strategy helps you manage risk and reduces volatility from overexposure to a single market, industry, or individual stocks and bonds. There will always be some risk when you’re investing and diversification is not a proven strategy for preventing loss. Instead, the goal of an investment diversification strategy is to improve the potential for returns on your portfolio — no matter what your risk tolerance is.
Many different types of investments suffered losses during the 2008 – 2009 bear market. However, portfolios that were well diversified were able to contain their losses better than portfolios that were heavily exposed to a single asset class. Diversification is one important component of staying invested when the market fluctuates.
Even if you are a high-risk investor that wants to allocate 100% of your investment portfolio towards stocks. It’s nearly impossible to sort through every publicly-traded company and pick the one that will deliver the best returns. It makes more sense to spread your money between several companies within different sectors. This way, if one company or industry suffers a loss, but another one you’ve invested in performs well – you’re well-positioned. In this example, diversification can help even the riskiest investors maximize their long-term gains.
Determining Your Risk Tolerance
Your risk tolerance represents how willing you are to incur losses on your investment in exchange for potentially higher earnings. It is determined by your age, income level, investment goals, the time-horizon of your investments, and other factors.
Younger people generally have more risk tolerance than older folks because they have more time to recover from losses. Likewise, people with higher-income or more readily available capital may be more risk-tolerant than someone that wouldn’t be able to cover a major expense if their portfolio incurred a loss.
There are many ways you can determine your personal risk tolerance. Working with a financial advisor or financial planner can help you get an idea. Most robo-investing platforms or fully manageable online portfolios will also offer tools to help you determine your personal risk tolerance. Once you know your risk tolerance, you can work on implementing an investment diversification strategy that optimizes your portfolio.
Investment Diversification Strategies
Wondering how to properly diversify a portfolio? Take a look at the top qualities a stellar investment diversification strategy contains.
Diversify Between Asset Classes
Diversifying between asset classes means finding the asset allocation that works best for your risk tolerance. A portfolio that’s well-diversified between different asset classes like stocks, bonds, ETFs, mutual funds, etc. will be better positioned to manage risk in the event of a downturn. Even riskier investors can benefit from mild diversification into safer assets to minimize volatility.
You don’t want to be too heavily invested within a single geographical region. Natural disasters like droughts, fires, hurricanes, etc. can affect your investments and undermine your portfolio performance. Similarly, political tensions and international affairs can threaten your portfolio if you have major stakes within a single market, such as the U.K. or China.
Holding all your assets within a single industry sets you up to be greatly affected if that industry goes into decline. Even short-term setbacks caused by trade wars or other factors can have enormous implications for long-term growth. This holds true even if you hold different assets within the same industry, such as bonds, stocks, ETFs, etc., all within the energy or consumer goods sector. Ideally, you want to be invested in multiple different industries to increase your chances of steady portfolio appreciation.
Investing In Real Estate
Whether you choose to invest in a single investment property or a REIT, real estate is almost always likely to increase in value and become an asset – once paid off in full. Plus, real estate investing offers the additional benefit of passive income through rental payments. In fact, many investors seek out real estate primarily for the consistent monthly income rental properties provide.
The housing market doesn’t typically correlate with the stock market or asset classes – making real estate an excellent investment diversification strategy. Real estate also offers investors favorable tax benefits and the ability to leverage through a home equity line of credit, or heloc.
The primary downside to real estate investing is that it is a highly illiquid asset class. Properties can sit on the market for months or years before they are sold. If you’re going to invest in real estate, make sure you have enough capital to cover unforeseen expenses. Otherwise, real estate can be a valuable component of an investment diversification strategy.
Long & Short Term Investments
Your portfolio should be well-positioned to gain from both long-term and short-term investments. For example, ETFs and blue-chip stocks can almost guarantee gains. On the other hand, a short-term investment in a new company may give your portfolio a boost, but may also prove unsuccessful in the long-run.
A winning diversification investment strategy is to hold a healthy balance of both long-term and short-term investments. The exact ratio should be determined from your risk tolerance. If you are more risk-averse, it might make more sense to give blue-chip companies more weight within your portfolio.
Rebalancing Your Portfolio
Rebalancing your portfolio entails buying or selling different assets to restructure the diversification levels and asset allocation of your investments to reflect your new financial situation and risk tolerance.
There’s no guarantee that the factors that determine your risk tolerance will remain the same. As your life evolves and your income level and investment goals change, you’ll naturally want your investment portfolio to reflect your new situation. Likewise, if economic or market factors have influenced the assets you’ve invested in, you may want to make some adjustments to your portfolio. This is where rebalancing your portfolio comes in.
When Should You Rebalance Your Portfolio?
It’s important to continuously monitor how your investments are performing as well as periodically make adjustments. Some investors have found it helpful to rebalance their portfolios on a monthly, quarterly, or annual basis – as well as during times of market volatility.
As a beginner, knowing when to rebalance your portfolio can be a challenge. You may want to consider hiring an experienced financial advisor to provide personalized advice and help you make these decisions. Fully-managed robo-advisors can also provide quality guidance when needed. In the meantime, be on the lookout for these key factors that may signal it’s time for you to rebalance your portfolio.
- Changes to your income level: Did you receive a promotion or switch to a higher-earning position? Or perhaps you’ve recently been laid off or lost a major client. Whichever the scenario, you’re going to want to rebalance your portfolio to reflect your new income level.
- Receiving a major influx of cash: If you’ve received an inheritance, payment from a legal settlement, or another large bonus — it makes sense to reconsider your asset allocation or investment strategy.
- You have a baby: Becoming a parent changes many things in your life – and your portfolio should be one of them. You’ll need to prepare for major future expenses that come with raising your child and their future education.
- You’re approaching retirement: As you approach retirement, your portfolio has less time to recover from market downturns and losses. You’ll want to make adjustments to ensure the capital you’ve accumulated stays well protected even in a bear market.
- Market fluctuations: If one asset class performs exceptionally well — or severely underperforms — the asset allocation in your portfolio may become skewed. You’ll want to make changes to rebalance your portfolio according to new market conditions.
Why you should diversify your portfolio
Diversifying your portfolio is one of the most important things you can do to mitigate risk and better position yourself for growth. A quality investment diversification strategy will consider your asset allocation — along with balancing different asset classes, geographical differences, industries, real estate assets, as well as long-term and short-term investments.
Looking for the next steps on how to properly diversify your portfolio? We recommend consulting with a professional financial advisor who can provide personalized advice for your unique financial situation. Robo-advisors are also another way to receive customized support.
All in all, diversifying your investment portfolio is key to yielding higher returns.