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Make no mistake about it, diversification is crucial when building a long-term portfolio.
After all, you won’t get all of your investment-related decisions right, so it’s important to ensure that you are not overexposed to a small number of assets or markets.
In this guide, we explain how to diversify your portfolio so that you can grow your wealth over time in a risk-averse manner.
What Is Portfolio Diversification?
In a nutshell, portfolio diversification refers to the age-old investment principle that you should never put all of your eggs into one basket. That is to say, rather than investing in a small number of stocks or ETFs, you should broaden your horizons as best as possible.
Although we will get to the specifics of asset allocation later, the main concept here is that you are spreading your risk across multiple assets, markets, and economies. In doing so, you won’t feel the brunt anywhere near as much if one of your investments doesn’t go to plan.
Note: Holdings in a diversified portfolio can be spread across a number of asset classes, sectors, industries and geographically.
How to Diversify a Portfolio?
If you’re learning how to diversify your portfolio for the very first time, below you will find a couple of simplistic examples to help clear the mist.
Let’s suppose that you are new to the financial markets and you have $10,000 to invest.
- You like the look of Apple and Tesla stocks, so you decide to invest $5,000 into each company;
- After six months, Apple has performed reasonably well, as the shares are now worth 20% more;
- This means that your Apple shares are now worth $6,000 ($5,000 + 20%);
- However, Tesla has since entered a prolonged downward trend and the shares are now worth 50% less; and
- This means that your Tesla shares are now worth $2,500 ($5,000 – 50%)
As per the above example, your original $10,000 investment is now worth just $8,500. Sure, Apple stocks have returned a profit for you, but Tesla’s 50% drop means that your initial investment is now worth less.
Sticking with the same $10,000 example, now let’s give you a picture of what a well-diversified portfolio might look like.
- You invest 10% of your portfolio in 10 growth stocks that you like;
- You invest 15% of your portfolio in 10 dividend stocks you like;
- You invest 25% into an S&P 500 index fund;
- You invest 35% into fixed-income bonds;
- You invest 10% into a gold ETF; and
- You invest 5% into Bitcoin.
As you can see from the above, your portfolio is now home to a magnitude of asset classes and financial instruments.
For example, not only have you covered a personal selection of growth of dividend stocks, but you have also invested in all 500 companies listed on the S&P 500. To ensure you are not over-reliant on the US stock markets, you have also allocated funds into bonds, gold, and Bitcoin.
Although simplistic, this is a great example of a well-diversified portfolio. After all, if one of the financial instruments within your portfolio doesn’t perform well, some of your other assets should counter these losses.
Understanding Assets and Markets
Before you can begin your asset allocation journey, you first need to have a firm understanding of what financial instruments you have at your disposal. For example, you likely know how stocks and shares work, but you also need to assess the type of equity you are investing in and what level of risk each one represents.
- For example, blue-chip stocks are perceived to offer the lowest level of risk, not least because these are companies that are highly established, have stable earnings, and are leaders within their respective sectors.
- Think along the lines of Salesforce, Johnson & Johnson, Microsoft, Disney, and Nike.
You then have growth stocks, which attract a higher level of risk to your portfolio. This is because growth stocks are often perceived to be behind products or services that are unproven or they simply haven’t been around long enough to establish a track record in their industry.
- On the other hand, the upside potential with growth stocks is going to be much higher in comparison to blue-chip companies.
- This segment of the stock industry would include the likes of Tesla, Alibaba, Uber, Airbnb, Square, and Coinbase.
Outside of the stocks and shares arena, you should take a look at the fixed-income sector. At the forefront of this are bonds, which also come with various types and risk/reward levels.
- At the lower end, you have US Treasuries, which are about as risk-free as you will get in the financial markets.
- For higher levels of income, you then have corporate bonds, which are issued by medium-to-large companies.
Finally, you have alternative investments, which can offer a higher risk and reward spectrum. But, not only are these more volatile, but you likely won’t have access to any income.
- This would include the likes of gold, silver, and even Bitcoin.
- Alternative investments can be great for diversification, as they allow you to hedge against the traditional stock markets.
Ultimately, by understanding the nuts and bolts of how each financial instrument works, you will give yourself the best chance possible of creating a well-diversified portfolio that aligns with your financial goals and tolerance for risk.
Pro Tip: Portfolio diversification is a great strategy to limit risk, however it can also hurt performance — at least in the short term.
The most effective way of balancing risk and reward is through asset allocation. This is a strategy that aims to find the perfect blend between each asset class and financial instrument within your portfolio.
The end game is to grow your wealth over time by finding the equilibrium between risk and profit potential. There is no secret sauce in this respect, as each investor will have unique financial objectives and risk profile.
To be even more specific, you will also need to consider factors such as your age and time horizon.
For example, if you are still young and have several decades before you plan to retire, you might find that your asset allocation strategy is more weighted towards financial instruments with a slightly higher level of risk. This might mean that you have much more of a focus on stocks than low-risk bonds.
At the other end of the spectrum, if you have already built a sizable nest egg and are approaching your age of retirement, then you will likely want to allocate more of your portfolio to fixed-income assets with a lower risk profile.
This might include high-grade government and corporate bonds, as well as a diversified selection of dividend stock ETFs.
To give you an idea of what to consider when allocating assets to your portfolio, below we explain the three commonly used models:
If your portfolio is focused on an income model, this means that most, if not all of your assets will attract a minimal amount of risk and, of course, generate regular income. This will come in the form of dividend stocks or bonds that yield coupon payments.
Some example splits of an income asset allocation model include:
- 100% bonds — 0% stocks and other assets
- 80% bonds — 20% stocks and other assets
- 70% bonds — 30% stocks and other assets
This particular model will often be deployed by those towards the end of their long-term investment journey seeking low-risk income.
As the name suggests, a balanced asset allocation model will see your portfolio more evenly split between income-generating assets and those that target growth in the form of capital gains.
Some example splits of a balanced asset allocation model include:
- 50% bonds — 50% stocks and other assets
- 40% bonds — 60% stocks and other assets
- 60% bonds — 40% stocks and other assets
Those taking a balanced approach to invest might be looking for the perfect balance between risk, short-term volatility, and medium-to-long-term growth.
Put simply, those focusing on growth asset allocation will look to generate the highest returns and are likely towards the start of their long-term investment journey.
Some example splits of a balanced asset allocation model include:
- 100% stocks and other assets — 0% bonds
- 80% stocks and other assets — 20% bonds
- 70% stocks and other assets — 30% bonds
As you can see from the above, the vast majority of assets in this portfolio will consist of stocks, with a smaller amount of capital allocated to fixed-income bonds.
It is important to note that unless you are investing through an actively managed fund — you will need to regularly reconsider your asset allocation model.
In doing so, this will ensure that your portfolio is closely aligned with your current financial goals and risk tolerance, which is likely to change over time.
Pro Tip: When building your portfolio, your strategy should be tailored according to your goals, time horizon and risk tolerance.
Ways to Diversify Your Portfolio
So now that you know the basics of how to diversify your portfolio, we can now dig a little bit deeper regarding some of the best approaches to take.
Consider Target-Date Funds
A good starting point when thinking about the best ways to diversify your portfolio is to consider a target-date fund. For those unaware, these typically operate like traditional mutual funds that are actively managed.
This means that the provider will determine which asset classes, financial instruments, and industries are right for you and your financial goals. Crucially, the target-date fund will determine which asset allocation model is best suited for your needs based on your age and time horizon.
For example, if you’re young and plan to invest for several decades, you might be assigned a 30-year target that initially takes an 80/20 split on stocks and bonds respectively. Or, if you’ve only got 10 years until retirement, the target-date fund might take an 80/20 split in favor of bonds.
Consider Low-Cost Index Funds
The next option to consider when thinking about how to diversify your portfolio is to look at low-cost index funds. These can either come in the form of an ETF or mutual fund. Either way, the index fund will aim to track a specific marketplace, of which there are many.
In the equity sector, for example, the S&P 500 tracks 500 large companies that are listed in the US. You then have the NASDAQ 100, which tracks the 100 largest companies on the exchange of the same name. These and all other stock index funds are regularly rebalanced and reweighted, the latter usually based on market capitalization.
Low-cost index funds are not just reversed for the stock markets. On the contrary, there are index funds that track bonds too, which is another great way to diversify.
Some index funds even track specific economies or regions, such as stocks and bonds located in the emerging markets. These do, however, often attract slightly higher annual fees.
Diversify Across Different Asset Classes
We have already discussed the importance of diversifying across different asset classes, so we don’t need to go into too much detail here. But, to recap, the main concept here is that a well-diversified portfolio will always contain a wide variety of assets.
Whether that’s a blend of blue-chip, growth, and dividend stocks, index funds, bonds, or commodities, consider increasing your exposure to multiple investment classes. The most challenging aspect is determining what asset allocation split to take. We covered this earlier.
Diversify Across Different Sectors
Seasoned investors will also look to diversify across multiple sectors. This is especially important when investing in the stock markets — as certain sectors will often perform better or worse than others.
For example, in the midst of the coronavirus pandemic in March 2020, it was technology-based stocks that led the way for the rest of the year. The likes of Apple, Amazon, Facebook, and Alphabet all enjoyed tremendous double-digit growth.
On the flip side, other sectors — such as oil and gas, retail, and aviation — all suffered significant losses during the same period. With this in mind, it’s important that your portfolio, at least in the case of stocks, is well-diversified across multiple sectors.
As a side note, the S&P 500 is home to 11 main market sectors, which you will find below for reference:
- Consumer Discretionary
- Consumer Staples
- Health Care
- Information Technology
- Real Estate
To take things to the next level, you can also diversify across specific industries, which we cover in the section below.
Diversify Across Different Industries
While 11 S&P 500 sectors might seem like a lot, risk-averse investors will look to diversify within each segment.
Let’s take the energy sector as a prime example. You could niche down into specific industries like oil, gas, and renewables. Similarly, in the real estate sector, you can diversify across companies involved in commercial, residential, healthcare, and retail properties.
Perhaps the best way to diversify across different industries is to look for ETFs that track a specific marketplace.
Market Capitalization Diversification
For those unaware, the market capitalization of an asset refers to its total value at any given time.
This term is typically used in the equity markets. Here, market capitalization refers to the current stock price multiplied by the total number of stocks in circulation.
This is relevant in the context of how to verify your portfolio as you might consider spreading your capital across various company sizes.
For example, while you might have the vast bulk of your capital invested in large-cap stocks that present the lowest risk, you might also allocate some funds to small and medium-cap companies.
While you might be looking to focus exclusively on assets listed in the US, seasoned investors will also look to diversify across different regions.
After all, if the US stock markets are on a prolonged downward trend, this isn’t to say that the same bearish sentiment will be found in other economies.
If you are to consider geographical diversification, consider the risk profile of each specific region. For example, it could be argued that lower-risk economies include the likes of the UK, Europe, Japan, and Australia.
Higher-risk economies are largely found in emerging markets. This might include countries such as South Africa, Brazil, India, Thailand, and the Philippines.
The good news is that there are several ETFs that specifically take a geographical approach to diversification. This means that you can invest in thousands of stocks from a wide variety of countries and risk profiles — all through a single trade.
Note: It is recommended to seek professional advise when planning your diversification strategy to ensure you are not going overboard with your portfolio diversification.
Benefits of Diversifying Your Investment Portfolio (Pros)
The main benefits of portfolio diversification are as follows:
- Avoidance of overexposure to a small number of assets
- Reduction of short—term market volatility risk
- Protection from capital investment decisions that don’t go to plan
- Lower financial impact of prolonged bear markets
- Improved chances of selecting an asset that generates above-average gains
- Target growth in two forms — income generation and capital gains
- Portfolio alignment based on long—term financial goals and risk tolerance
Drawbacks of Diversifying Your Investment Portfolio (Cons)
Although most seasoned investors will look to build a well-diversified portfolio, there are also many drawbacks to consider:
- Diversification across many different assets and markets can be time-consuming
- Diversification can be costly if using a broker that charges a flat commission
- Some financial instruments in the portfolio will likely be low-quality assets
- Broad investment decisions can limit financial returns
FAQs: How to Diversify Your Portfolio
Below, you will find a list of commonly asked questions from those exploring portfolio diversification.
Why Do You Need to Diversify Your Portfolio?
By diversifying your portfolio, you are spreading your investment funds across multiple assets, financial instruments, markets, sectors, and even economies.
Ultimately, this is with the view of ensuring you are overexposed to a small number of assets, So, you are reducing your long-term investment risk.
Can Too Much Diversification Hurt My Returns?
There is always the potential that too much diversification can hurt your long-term growth potential. After all, by investing in too many assets, you are increasing the likelihood that you will be adding low-quality instruments to your portfolio.
What Is a Good Diversified Portfolio?
A well-diversified portfolio will initially involve thinking about what your long-term financial goals are and how much risk you feel comfortable taking. A good way of doing this is to review the asset allocation models we discussed earlier in this guide.
For example, let’s suppose you elect to take a balanced approach via a 50/50 split of stocks and bonds. In this instance, you then need to niche down further by thinking about which type of stocks and bonds to add to your portfolio.
This might include a collection of growth and blue-chip stock ETFs, alongside a basket of corporate and government bonds.
Which Types of Investments Can Make up a Diversified Portfolio?
Put simply, a well-diversified portfolio can include every type of investment class imaginable. Whether that’s stocks, ETFs, index funds, gold, Bitcoin, REITs, or bonds, all financial instruments should be considered!
What Is an Example of a Diversified Portfolio?
A simplistic example of a diversified portfolio might consist of 35% in stock index funds, 30% in selected blue-chip companies, 30% in high-grade government bonds, and 5% in alternative assets.
In summary, diversification is one of the most important concepts you can learn when investing in the financial markets. As we discussed extensively in this guide, the overarching concept is that you will be invested in a wide variety of assets and instruments to mitigate portfolio risk.
This means that, while you will always encounter investment decisions that don’t go to plan, your other assets should counter these losses.
The most important thing is that you spend some time thinking about your financial objectives, investment time horizon, and tolerance to risk. In doing so, you’ll give yourself the best chance possible of building a well-diversified portfolio that offers the perfect balance between risk and reward.
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Kane is a highly-skilled researcher and writer with expertise in finance, trading, and cryptocurrencies. Academically, Kane holds a Bachelor’s Degree in Finance, a Master’s Degree in Financial Crime, and he is currently engaged in a Doctorate. He is passionate about researching the money laundering threats of the virtual economy — notably, cryptocurrencies and blockchain technology.