Ways to Diversify your Investment Portfolio
Diversification is a general technique for reducing risk of investment.
Diversify a Financial Portfolio can help reduce risk and act as a safety net for bad investments.
Diversification is a general technique for reducing risk of investment. Each risk-averse investor needs to diversify to some extent in order to minimize the volatility in their portfolio. Volatility is limited by the fact that not all assets move up and down in value at the same rate.
Diversification does not ensure a profit, neither is a guarantee against loss, it reduces the likelihood of substantial losses under a wide range of economic circumstances. On the other hand, it limits the rate of growth. The values of different investments often move in opposite directions, therefore investing in a selection of securities reduces the risk that all securities will lose value at the same time. Dividing investments between different asset classes offers some protection against loss when one type of investment is underperforming.
Goals of Portfolio Diversification
The goal of this strategy is to spread the investor's portfolio across several assets. An undiversified portfolio, for example buying only one stock, is risky, if it loses its value, the investor may lose all of his or her money. A mix of asset classes has fewer extreme swings than a non-diversified portfolio. The return on a diversified portfolio is always lower than the highest return, therefore you lose the chance of having invested solely in the single asset that performs best, but you avoid having invested solely in the asset that performs worst. Diversification narrows the range of possible outcomes.
Diversifying an Investment Portfolio
The first step toward diversifying a portfolio is making an asset allocation plan including stocks, bonds, short-term investments, real estate and commodities. A diversified portfolio usually is divided over the following asset classes:
- Short-term investments include safe and conservative financial instruments such as money market funds and short-term certificates of deposit that ensure easy access to your money and stability of principal. They preserve the value of the investment, but over the long term, they generally have the lowest returns. Adding conservative fixed income investments helps modulate the ups and downs found in equity investments.
- Bonds - Investors who prefer safety to growth often allocate a high proportion of their money toward bonds that provide regular income and do not show high volatility. Bonds are considered as safe investments, although they do not offer very high returns over the long term. Further diversification can be obtained by investing in bonds from different countries, as they often perform differently than their U.S. counterparts.
- Stocks are the most aggressive portion of an investment portfolio. They offer the opportunity for higher growth, but carry a greater risk, especially in the short-term, as their value may decrease. The portfolio of stocks may be selected from a variety of industries, company sizes and types, such as growth stocks and value stocks. Certain industries perform better under certain economic conditions than others. A diversified portfolio should continue to build overall value under almost any conditions. Within industries, stocks from a mix of companies need to be purchased. A company stock in a good-performing industry may fail, but a group of diverse stocks within that industry have lower volatility. Global investors with an appetite for risk take advantage from geographic diversification, and allocate a proportion of their investments toward foreign stocks to capture some of the higher rates of return provided by the stock markets of Asia and Latin America.
- Real estate may serve an important role in a mixed asset portfolio, it may include lodging, multi-family, retail, office and industrial space. It is suitable for investors who have long-term goals, because these investments are less liquid.
- Commodities such as oil, gold, silver, etc. help protect against inflation. Besides, gold is considered as a “safe heaven” under difficult economic circumstances. Commodity futures might be risky, but small doses blended into a larger portfolio can mitigate risk.
- Mutual Funds - Many mutual funds have a great deal of diversification built in, they provide the chance to invest in a broad selection of stocks, bonds, commodities or real estate.
The key to reducing risk is to pick investments that do not typically move synchronized. When one performs poorly, another may do well. A well-diversified portfolio brings less volatile returns than one build up of investments that go up and down together. It will perform better during times of poor overall performance.