Most investors know it’s important to diversify to maximize potential returns, reduce risk, have a better and more stable portfolio, have more flexibility, and shield against volatility.
Here are 4 key strategies wealth managers recommend using when considering diversification of your portfolio.
- Determine Your Risk Tolerance
Your tolerance for risk is primarily based on your investment timeframe, which impacts how you should approach diversification and changes over time. When you invest in a long-term goal such as retirement or your newborn’s college fund, generally, you can afford to take some additional risk in search of a higher return because a long-term portfolio can ride out the ebbs and flows of the market.
However, as that goal gets closer, you don’t want the risk of a big sell-off right when you’re planning to liquidate your portfolio for cash. Based on your personal or business objectives, planning investments for different ranges of timelines including 6 months, 2 years, 5 years or 20 years is a good strategy. It will offer you funds in the long run without hampering your liquidity.
As U.S. Bank notes, most investors will fall into one of three buckets:
- Aggressive investors generally have time horizons of 30 or more years. With this flexibility, they have a higher risk tolerance and may allocate 90 percent of their money to stocks and just 10 percent to bonds.
- Moderate investors, who have approximately 20 years before they need their money, generally allocate a lower percentage to stocks than an aggressive investor. For example, they may have 70 percent of their funds in stocks and 30 percent in bonds.
- Conservative investors, those who have little risk tolerance or will need their money in 10 or fewer years, may do a 50/50 balance between stocks and bonds.
In addition to timeframe qualifiers, the other types of risk are market and diversifiable. Market risks are associated with exchange rates, inflation, interest rates, or political instability and cannot be eliminated or mitigated through diversification.
Diversifiable risks are specific to a company, industry, market, economy, country, or region and can be mitigated by diversifying your investments in different asset classes across different markets.
- Diversify Across and Within Asset Classes
A primary strategy in diversifying your portfolio is simply to invest your money across at least two or three different asset classes such as stocks, real estate property, fixed-income bonds, commodities, CDs, foreign currencies (FOREX), or private equity.
Asset classes have varying levels of risk and returns that determine what makes them successful, so including investments across different categories will help you create a diversified portfolio.
Additionally, diversify within each asset class. For example, if you buy stocks, spread those shares out across different industries such as biotech, manufacturing, retail, technology, travel, or finance.
If you invest in commodities, spread those out between grains, gold, beef, oil, or natural gas. Look for bonds with different maturities and from different issuers, including the U.S. government and corporations. Within each asset class, make sure you’re not overly exposed to one area or another.
- Think Globally
In the 21st century, desktop technology can give you instant access to a plethora of financial markets around the world. Not only can you have a diversification strategy based on geography but investing overseas will allow you to adjust your level of risk.
Part of your investments can be in traditionally more stable and developed markets such as the U.S. and Europe while you allocate another percentage to other smaller markets such as Hong Kong or Australia that might be more volatile but are geographically distant.
This strategy also lessens your exposure to political and geopolitical risks as well as regional calamities (such as war or a natural disaster) that might send financial markets in affected areas tumbling.
For example, if you only own U.S. stocks and bonds, your entire portfolio is subject to U.S.-specific risk; however, foreign securities can increase a portfolio’s diversification but remember they are also subject to country-specific risks, such as foreign taxation, currency risks, and risks associated with political and economic development.
- Review and Rebalance
Because your risk profile changes over time, it’s imperative to periodically rebalance your portfolio.
Review and re-define your short-term and long-term goals because understanding your objectives will help you analyze and adjust the funds that you are or should be investing in.
Even if your portfolio is already well-diversified, wealth managers recommend periodically rebalancing your portfolio because certain investments will gain value, while others lose value over time.
“Rebalancing is a negotiation between risk and reward that can help your portfolio stay on track amidst the market highs and lows,” said Chris Lean, investment director, Aisa International. “There are certain situations that might trigger rebalancing, including market volatility and major life events.”
For example, you can rebalance your portfolio by investing extra money, such as a tax refund in an investment you want more exposure to. You could sell some investments and put the proceeds in other types of asset classes. You might want to sell a stock position at a loss to offset an earlier gain.
If inflation drives interest rates up, you might want to put cash into a high-yield money market account. Tweaking your portfolio by rebalancing and reallocating your investments is a common strategy among the pros.
Snapshot: Pros/Cons of Diversification:
Pros
- Preserves capital, especially for retirees or older investors
- Risk Mitigation
- Safeguard Against Market Fluctuations
- Reduced Volatility
- Leverage Growth
- Improved Portfolio Performance
- Risk-Adjusted Protection Against Losses
- Varied Opportunities/Wider Exposure
- Makes Investing More Fun/Interesting
- Protection from Unexpected Events
Cons
- Can be Complicated/Intimidating
- Can Be Risky
- Varied Taxation Laws
- No Guarantees
- Requires More Research, Time, and Effort
- More Opportunities for Mistakes
- Cumbersome to Manage
- Transaction Fees/Brokerage Costs
- Does Not Offer 100% Protection
- Requires Continual Adjustments
As Bloomberg says, “Diversifying your portfolio isn’t zesty, but it works.” No matter what strategies you use, diversification is not simple and requires time and management to be effective.
No one can predict exactly what any investment will deliver over time, but by finding new growth opportunities, varying asset classes, and mitigating losses from market volatility, you can ensure you have the proper liquidity to meet your current and future financial needs.
“Diversification can definitely help in managing risk and reducing the volatility of an asset’s price movements, but remember, no matter how diversified your portfolio is, risk can never be eliminated completely,” Lean added.
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The views expressed in this article are not to be construed as personal advice. You should contact a qualified and ideally regulated adviser in order to obtain up to date personal advice with regard to your own personal circumstances. If you do not then you are acting under your own authority and deemed “execution only”. The author does not accept any liability for people acting without personalised advice, who base a decision on views expressed in this generic article. Where this article is dated then it is based on legislation as of the date. Legislation changes but articles are rarely updated, although sometimes a new article is written; so, please check for later articles or changes in legislation on official government websites, as this article should not be relied on in isolation.
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