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Ever heard of that old adage, “don’t put all your eggs in one basket”? Well, the saying holds especially true for investors looking to save money. If you’re new to playing the financial field, diversification is something you’ll need to learn a lot about. We’ve compiled a guide to get you through the basics and teach you how to diversify your investment portfolio –and why it really matters.
What does it mean to diversify your portfolio?
Diversifying your investment portfolio, or diversification, means to spread your investment money among several different types of investment assets or classes. The goal is to not invest everything in one area. For example, if you put all of your money in automobile stocks or all of your money into real estate, you are not diversified.
Why should I diversify my portfolio?
Diversification is done in the interest of moderating the risk of an investment performing poorly. If you are completely invested in stock, for example, and the market goes down, your whole portfolio suffers and your money can be wiped out in a single day. Diversification prevents you from loss because even if one of your investment holdings completely tanks, it won’t drag down the rest of your portfolio. Most people are more motivated by loss avoidance than by potential gain, which is why they choose to diversify rather than ‘put all their eggs in one basket’. However, with the right strategy, a sophisticated investor who creates a diversified portfolio can generate significant growth. In a survey of nearly 700 high net worth individuals, both men and women reported that growing assets was more of a priority than preserving them.
While there might be a cadre of investors who are content with generating income from their portfolios without growing them, most prefer to see those little nest eggs increase over time – and in various areas.
How do I diversify my portfolio?
You can start diversifying by deciding which types of investments you choose to make. A good starting point is to find a balance between exchanged-traded funds (ETFs), such as stocks and bonds, and mutual funds. Mutual funds pool your money with other investors, and unlike ETFs who trade throughout the day, trade only at the end of the day at the net asset value price. The graph below shows the distribution of mutual funds and ETF assets in the United States for 2016:
If you’re interested in investing in these classes, this 2017 survey conducted by the International Investment Funds Association indicates that 42% of investors think domestic equity funds are the way to go. As you get more advanced with your investing, consider adding other types of assets to your diversified portfolio. Additional options include:
- Peer-to-Peer Lending
- Real Estate
- U.S. Treasury Securities
Forms of Diversification
You can diversify your portfolio is six different ways:
- Asset Class: using various forms of investments
- Individual Company: a bevy of different index funds
- Industry: technology, retail, etc.
- Geography: regional or international diversification
- Time: dollar-cost averaging
- Strategy: combining various risk factors
Popular Portfolio Types
Building a diversified portfolio will require research and effort. You’ll also decide need to decide how you want to get a return on your investment based on your financial goals. A first time investor seeking an income portfolio might have their hands full with a rental property and the necessary tenant verification, while someone with more experience might decide to take on a more aggressive stance.
Aggressive portfolios tend to include a basket of stocks that are high risk/high reward, while defensive portfolios seeks to minimize downside capital losses. Choose a portfolio style that suits your lifestyle, experience level, and willingness to gamble. If you’re unsure of what risk you’re willing to assume, build hybrid portfolio. Hybrids are the ideal form of diversification, as they venture into bonds, commodities, real estate, and even art.
In the end, any portfolio you decide to build will come with some sort of risk. Diversifying your investments is the best way to mitigate against potential loss, so start researching different ways to redirect your money.
Article written by: Adam Pepka