Portfolio diversification is a risk management strategy that can be simplified by remembering the adage: don’t put all your eggs in one basket. When applied to investing, it means avoid putting all your cash into one company, market or asset class.
The reason for diversifying your portfolio is to protect your money when the market, or certain sectors, go through turbulent times. Often when one sector of the market is performing well, another might be dragging behind – or even dropping. If your investments are balanced via portfolio diversification, you’ll be able to even out wins and losses as the asset classes counteract one another, and you’ll continue to grow your wealth.
Read on to find out how to balance your investment portfolio, diversify with confidence and reap the benefits.
A balanced portfolio is one that spreads money across different asset classes and investment products such as ETFs (exchange traded funds), REITs (real estate investment trust), bonds and commodities. It can also include investments in products that you know well, trust, and use in your daily life.
It should also seek out investments in markets beyond your home country, or continent. If your home base is Europe, consider the North American market and Australasia. Beyond that, consider global market options. Your knowledge of these regions might be limited at first, but investing is a great motivator to gain an understanding of what’s moving these markets.
Index and bond funds are seen as a safehouse when the market is navigating stormy conditions.
Index funds seek to track a particular benchmark index, such as the Nasdaq 100 or the S&P 500. In fact, Warren Buffet famously said that investing in the S&P 500 index fund was the best thing most people could do to protect against volatility. These funds are considered safe because they’re long term investments that will deliver slow but steady growth, and are usually paired with low fees.
Bonds are the most common form of fixed-income funds, and can be explained as a loan from you to a corporation or government as they raise funds for projects. Generally speaking, they’re favoured for providing stability, and a steady stream of interest income to investors for the duration of the bond. There are many variations of bond products, so research to find one that fits your individual financial circumstances.
If you’re a beginner building an investment portfolio, diversify using ETFs. Essentially, an ETF is a basket of different investments, including bonds, commodities, stocks and other investment vehicles – this makes them a highly popular tool for diversification.
The ETF will usually have a theme (an EV theme would include a number of electric vehicle manufacturers and companies along the supply chain), or seek to track an index, and can be localised or offer a global reach. The ETF will give exposure to many different companies and market sectors at a lower cost than the investor attempting to do this on their own merit.
Inflation is hitting headlines globally, which makes this a good time to talk about commodities.
Commodities are viewed as a diversifier asset class, and can be broken down into two categories: hard and soft. Hard commodities generally require mining: gold, copper, natural gas, crude oil and aluminum. Soft commodities are usually grown: wheat, corn, soybeans and cattle.
What makes commodities a great option for diversifying is that when inflation increases, so does the price of most commodities. This means they offer protection against the effects of inflation. That said, commodities can be volatile, but as they have a low correlation to traditional asset classes, the risk to the overall portfolio can decrease.
One of the common mistakes investors make when building a portfolio is to stretch their money across too many investments in an attempt to diversify. Resist the temptation to extend into 40+ investment products and keep the number to around 20. This will allow you to concentrate your money, and put more time and effort into monitoring the market conditions that affect those particular investments.
Falling in love with a stock might sound bizarre, but it happens: think of the bright shiny Tesla stock, or memestock Gamestop. Pouring your capital into a stock you wholeheartedly trust and believe in might seem like a good idea, but the experts will tell you otherwise: the golden rule is to not allocate more than 5-10% to any single investment, no matter how much you love it.
With any investing, it’s important to keep your emotions in check. The point of a diversified investment portfolio is to level out the losses from an underperforming stock or market, with other options that are doing well. If one stock is performing particularly well, enjoy the success – but don’t overreact and sell the rest of your portfolio to buy more. Similarly, if a stock or product isn’t performing well, monitor it – but don’t panic and sell. Historically, the rewards of the market go to the most patient investors.
In summary, for a healthy investment portfolio, diversify. This can be done by investing in stocks across different markets and countries, varying industries and risk profiles, and seeking out investment products such as bonds, commodities, real estate and ETFs. These might not offer quick wins and make you a millionaire overnight, but they will protect your portfolio during turbulent times.
Remember: don’t put all your eggs in one basket. Keep some in the basket, and fry, boil, poach and scramble the others.