Newcomers to the world of investing are often greeted by veterans with a consistent, and historically reliable piece of advice: diversify your portfolio. In other words, make sure your wealth is distributed across a variety of different assets within your portfolio to keep it safer and potentially maximize your long-term earnings.
This is almost universally considered to be excellent advice, and possibly the most important advice to follow as a long-term investor.
But how do you follow this advice appropriately? What do you need to do to keep your portfolio balanced and healthy?
First, understand why diversification is important. Diversification is a way of hedging against risk; if your portfolio is exclusively allocated to stocks and the stock market tanks, you could lose everything.
In contrast, if only 40 percent of your portfolio is in stocks, the stock market tanking can take no more than 40 percent of your wealth.
Diversification is also important for maximizing potential gains. Every investment class has strengths and weaknesses, and because the future is uncertain, it’s impossible to tell which one is going to perform best over time.
Place your bets as you see fit, but if you distribute your wealth across many different asset classes, you’ll have a much more consistent, reliable rate of return, especially over the course of years and decades.
Diversification Tips to Keep Your Portfolio Healthy
The question is, what diversification strategies and tips should you follow to maximize the value you get from this approach?
The most important way to diversify your portfolio is to diversify broadly, meaning distributing your wealth across many different asset classes.
Allocating a portion of your portfolio to stocks, bonds, real estate, commodities, and even alternative investments like cryptocurrency can give you a kind of insurance against any one of these asset classes underperforming or suffering catastrophic losses.
However, it’s also important to diversify narrowly, within each asset class. For example, let’s say you’re actively investing in real estate. Real estate itself is a broad asset class that offers many feasible options for individual investment decisions.
You can invest in single family real estate or multifamily real estate. You can invest in commercial or residential real estate. You can invest in real estate in many different geographic areas.
A narrowly diversified portfolio will have real estate assets belonging to many different categories. You can practice something similar in the stock market by investing in stocks from many different industries, and in businesses of many different sizes.
Take advantage of index funds and ETFs
If you’re not sure where to start with diversifying, take advantage of index funds and exchange traded funds (ETFs).
These funds operate like baskets of individual assets, allowing you to indirectly invest in many different assets, and sometimes different asset classes, simultaneously.
Rather than cherry picking individual stocks to be part of your diversified portfolio, you can choose a fund that collects a variety of stocks from a single industry, or potentially from a handful of complementary industries.
Anticipate near-term changes
When diversifying a portfolio, consider near-term changes. For example, if you anticipate high inflation in the next few years, you should consider balancing your portfolio to reflect that.
If you suspect that a certain sector of the economy is going to thrive in the next decade, shift your holdings accordingly – just don’t go overboard. Ensure your portfolio will remain safe even if your predictions don’t turn out to be true.
Use dollar cost averaging
Dollar cost averaging (DCA) is a strategy that encourages investors to invest a fixed amount of money at consistent intervals, ignoring price fluctuations to have an average “buy in” price.
This is a way of diversifying your entry point in any market – but it’s especially valuable in highly liquid asset classes that enable investment at any time.
An example of this would be buying $500 of a particular index fund each month, regardless of the share price at the time.
Know your personal risk tolerance
There’s no such thing as a singularly perfect, diversified portfolio. That’s because different types of investors have different needs.
For you to have an appropriately diversified portfolio, you first need to understand your personal risk tolerance.
You may prefer a more aggressive or a more conservative portfolio, even within your peer group – what’s important is that you have your goals and values in mind when making decisions.
Reassess asset risk periodically
Generalities are very useful for new investors; for example, bonds are relatively safe, while stocks are relatively risky.
But asset classes don’t always have the same risk, and the risk associated with each asset class may change dramatically in the future.
Accordingly, it’s important to periodically challenge your assumptions and reassess asset risks.
Rebalance at regular intervals
Finally, be ready to analyze your portfolio diversification and rebalance at regular intervals. Many investors find an annual rebalance to be the right fit, but depending on your goals, you may need more frequent or less frequent assessments.
Diversifying a portfolio doesn’t have to be complicated, nor does it have to be stressful. Understanding these key fundamentals, and employing them consistently, can be ample for protecting your assets and eventually attaining a much more reliable return.
Just make sure to do your due diligence before making any major financial decisions.