Portfolio Diversification – the Whats, Whys, and Hows of it all!

Darryl Bachmeier
Aug 16, 2020
Finance


Investors can minimize risk by spreading their efforts over different financial categories, such as investment vehicles and industries. By doing so, they also maximize ROI since the different areas won’t react to financial upheaval events in the same manner. Having said that, as an investor, you should know that diversification isn’t a guarantee against loss. It is, though, an important component that lets you reach long-ranged financial goals with minimal risk. So, now you know diversification, let us see what it does and how to make it work for you:

Diversify to Reduce Uncertainty

No financial market is without a certain level of uncertainty. So, for example, if all your investments are going to the stock market, crashes can cause you to lose them. That’s also true for other markets, including real estate, currency, etc. The main reason diversification functions is because all markets don’t usually crash at the same time – or in a similar way. Look at the state of things due to the coronavirus pandemic. It hit various sectors differently and to a varying extent. But diversification doesn’t just work due to intermarket differences. It is so effective in part due to the dissimilarities between investments in the same asset class. Stock of different companies hailing from various sectors won’t fluctuate in the same pattern. So, invest across the sectors to bring down the probability of losing substantial amounts.

Allocating Assets to Keep Winning

Asset allocation isn’t just dependent on the kind of assets you choose. Other factors also play their part, particularly the following:

Time Horizon

The number of units of time during which you will keep investing to achieve a certain financial goal is your time horizon. Longer time horizons make riskier and volatile investments safer. That’s because you can wait out the situation until it improves. However, someone like a student saving up for their education, would have a shorter time horizon. They cannot take on risky investments. In other words, invest based on the length of your time horizon.

Risk Tolerance

How much can you – and will you – risk your original investment in exchange for greater ROIs defines risk tolerance. Aggressive investors usually have a high-risk tolerance. Therefore, they’d be willing to place more of their money at risk. On the other hand are conservative investors who would like to preserve most of their original investments. Decide which of these applies to you better and invest accordingly.

Rewards

Since the two are inextricably entwined, you may have to risk some to gain some. It’s true that all investments are risky; it’s the level of risk that can vary between each venture. Usually, though, with greater risks comes a greater ROI. So, those who have longer time horizons and a higher tolerance for risk should carefully invest in stocks and bonds, instead of cash equivalents. Investors who have short-term financial goals may be more suited to investing solely in cash. As we’ve been saying, it depends on when and what goals you have.

Choice of Investment

Types

So many types of investment vehicles exist out there. Some of them are:

  • Stocks
  • Money market funds
  • Stock mutual funds
  • US Treasury securities
  • Corporate bonds
  • Lifecycle funds
  • Municipal bonds
  • Exchange-traded funds
  • Bond mutual funds Healthy and diverse portfolios – or ones with multiple financial goals – are better served by investing in a mix of vehicles.

Direction

Financial turmoil will force different assets to behave in different ways. The price of gold, for instance, won’t go down during recessions. Stocks, however, get affected badly in that time. So, when you choose assets that move in different directions, you can offset the losses in one area with the gain in another. Are things rapidly becoming confusing for you? Then we’ll simplify them. Don’t handpick your investments yourself. Get into mutual fund where your money will go into various assets as part of the pool of money from other investors. Mutual funds invest in a range of vehicles, such as stocks, gold, bonds, and cash. That said, no two mutual funds are alike. Discuss your options!

Customization 

Customize the assets you put your money into in ways that suit you best. For instance, some investors will make that distinction by investing in the stocks of several industries. Even if a world event adversely affects one or some of these, they won’t lose all of their hard-earned money. Sure, the pandemic brought heavy casualties to airlines and cruise operators in the last year. However, retail ecommerce businesses saw a boom in sales. For best results, don’t dedicate more than 4% of your portfolio to one type of stock. Additionally, pick some for growth and others for value. Besides choosing several industries, you can also base your investments on company size. Smaller companies shouldn’t be completely overlooked in favor of household names. While the former may not be as widely known or as substantial, they do have more opportunity for growth. Some of them will fail, too, so don’t go all-in. For budding investors, we’d recommend diversification in various areas while still protecting the capital. Use the guide above to ensure that your strategy is a good one!

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