When it comes to investing, diversification is how we manage risk. You can diversify your investment portfolio by mixing a variety of financial instruments. The goal of diversification is to minimize the impact that any particular security will have on the performance of your portfolio as a whole. To put it simply, you don't want to put all your eggs in one basket.
Diversification has been around for a very long time. We can go back in time and see many investing blunders that have resulted from under-diversified portfolios (i.e., the dotcom crash and the Great Recession). You can liken the concept of diversification to insurance. As such, the time to diversify your portfolio is before diversification is necessary. A well-diversified portfolio can perform well when times are good and weather even the choppiest of market waters when times are bad.
These are the strategies you need to build a well-diversified portfolio and see your investments thrive even when market conditions are uncertain.
Balance risk and return
Diversification can protect you from devastating losses, but it can also cost you in average annual returns. In the financial markets, risk and return go hand-in-hand. Therefore, anything that reduces your risk will also reduce your return.
If you are a younger investor, you can afford to take more risk because you have the luxury of time. Why is this important? Because having more time gives you the ability to withstand the "highs" and "lows" the stock market will inevitably have. Younger investors should diversify with riskier assets, like stocks. Older investors should consider adding more bonds to their investment mix.
Finding an investment mix geared to you is essential. However, if additional risk will keep you up at night, you must find an investment mix that works for you. Plus, you will save money on anti-anxiety meds and antacids.
Don't be afraid to mix it up
You may be tempted to put all of your money into one stock or a specific sector, but resist this urge. Instead, create your portfolio by investing in several companies you know, trust, and even do business with in your day-to-day life.
To take things a step further, you should be considering assets outside of individual stocks. These assets can include commodities, exchange-traded funds (ETFs), and real estate investment trusts (REITs). You can invest in domestic and foreign types of these assets to add an additional layer of diversification to your portfolio.
However, be sure you do not diversify to the point where you simply cannot manage all of your investments. You should not invest in 100+ different investment vehicles if you don't have the time or resources to keep up with each investment. Plan to limit yourself to 20 to 30 different types of investments, especially if you're new to investing.
Diversify with Bond or Index Funds
You should consider adding index funds or fixed-income funds to your portfolio. When you invest in securities that track specific indexes, you get instant and long-term diversification for your portfolio. Additionally, by adding fixed-income funds, you are further protecting your portfolio against volatility and uncertainty. Fixed-income funds do their best to match the performance of broad indexes and, as a result, try to reflect the bond market's value.
These funds typically come with low fees (which is something that you should be looking for). Additionally, these funds are reasonably easy to manage, which is reflected in the minimal management and operating costs.
Add Investments to Your Portfolio
It is vital that you continue to add investments to your portfolio. To stay on track, you can use dollar-cost averaging (DCA) to keep your portfolio well-balanced. DCA involves buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. This way, you can invest money on a regular basis into your portfolio while ensuring you are not investing too heavily in any particular area.
Manage Your Investments
Diversifying your portfolio is only half the battle. Just because you have set-up your portfolio doesn't mean you can ignore it entirely. Stay on top of your investments by evaluating them periodically for changes in strategy, relative performance, and risk.
You will also need to rebalance your portfolio from time to time. Rebalancing involves revisiting your investment mix to maintain the risk level you are comfortable with and correcting changes that result from market performance. You can set a rebalance "rule" like rebalancing if any part of your investment mix moves away from your target by greater than 10 percentage points.
Lastly, be sure to revisit your plan frequently to ensure it's still in-line with your financial circumstances and goals.
We have seen what happens when investors don't adequately diversify their portfolios. The result of being too heavily invested in one particular asset category can be devastating. These less-than-stellar results are precisely why we need to diversify our portfolios from the start. Remember, you want to be well-diversified before you need to be.