How do I diversify my financial portfolio?

One of the major questions new or beginner investors ask is, Do I put all my eyes in separate baskets (keep single investment portfolios), or do I put all my eggs in one basket (keep a diversified portfolio)? There have been diverging views on the topic of diversity from investors. While some fully support the idea to diversify, others completely disagree with it.

One of the most popular terms used by investors is “diversify”, which simply means strategically combining different assets in an investment portfolio. As “simple” as the idea of diversification may sound, it is usually one major challenge faced by not only new or beginner investors, but also some experienced ones too. Though a lot of investors may love to diversify (or are diversifying already), they just do not know how to do it.

Well, though we would love to show you how to diversify your financial portfolio, it is important to start from why the need for diversification in the first place.

Why You Should Diversify:

Diversifying reduces your risk

 Investments, by their nature, are usually risky. This is because there are aspects of it outside of our control (systematic risk) and aspects within our control or avoidable (unsystematic risk). When you diversify, you try to reduce as much unsystematic (avoidable) risk as possible as one asset’s risk may be balanced out by the returns of the other.

It keeps relatively volatility lower

 Volatility (how unstable or unpredictable an asset is) is so critical to investors that there is an index (Beta [β]) that assesses how volatile an asset is relative to the market. Therefore, diversifying an asset with a β = 1 with an asset with a β < 1 will potentially reduce the general volatility of your portfolio, making it relatively stable than others.

Increased Potential Returns

By reducing your risks and volatility, you are assured of a portfolio strategically positioned to outperform the market and other Indexes. The million-dollar tip here, though, is not to “over-concentrated” your portfolio nor “over-load” as this may lead to “unbalanced risk” and pricey portfolios respectively.

Diversifying Lowers Your Worry

 This is a very important non-financial benefit. Not only is investing is a logical process, but it is emotional too. Wrong investments get you stressed and worked up. Good investments get you excited and relaxed. By diversifying, you potentially reduce the emotional difficulties to a point while being hopeful that things will go well in the end.

Now that we know some of the benefits of diversifying portfolios, here are some ways to diversify your portfolio properly

1. Create Your Strategy Based on “GATM”:

“GATM” is an acronym that stands for Goal of investment (why you are investing), Age (how old you are), Time Horizon (how long you want to invest), and Market Cycle (current position of the market as markets usually have “cycles” that they follow). These are 4 major factors to determine how to balance your portfolio. For instance, a young investor with a steady source of income may not likely invest in assets that a retired married investor would due to their numbers of the 4 factors above.

2. Exploit Varying Classes of Assets:

A class of asset or asset class is simply a form or category of asset. There are three major asset classes: stocks, bonds and cash. Some experienced professional investments can accrue wealth in just one or two classes of assets over some time. However, to a retail investor (like most individual investors), this may not be helpful. Rather, it is best to consider balancing the different types of asset classes.

3. Don’t Forget Commodities and Real Estate:

Long before professional investments, people, in the past, stored their wealth in commodities such as gold and properties such as lands.

The beauty of investing in commodities and real estate is that they are barely affected by inflation. While other asset classes such as stocks are probably at the mercy of inflation, commodities and real estate rather seem to “benefit” as their prices appreciate over time.

Meanwhile, direct investment in commodities and real estate can be quite expensive for an individual retail investor. Thus, it is recommended to consider commodity ETFs (exchange-traded funds) and REITs (Real Estate Investment Trusts) which are less expensive. Other online platforms help you invest in these asset classes too.

4. Use Different Sectors To Balance Portfolio:

There are 11 main sectors when it comes to investment: consumer staples, utilities, energy, real estate, information technology, consumer discretionary, industrials, telecommunications, materials, financials, and healthcare.

The interesting thing about all these sectors is that each has a particular point or situation where they outperform the other. IT stocks, for instance, perform well in bull markets, while financials perform in high-interest rate situations.

By spreading your portfolio based on these sectors, you can be assured of reducing volatility in any sector. However, it must be done in moderation and be based on research.

5. Consider Foreign Market Investments:

Many Americans, for instance, may not willingly invest in Australia despite her export-driven economy and ability to avoid recessions for almost 30 years (including the Great Recession of 2008). Why is that?

It is normal to be exposed to local markets. That is quite understandable. Besides, we all can assume how volatile things may seem overseas in general.

Sometimes, some of the many investment opportunities may be in some foreign markets with higher returns that could be included in a diversified portfolio of local markets. This is referred to as geographic diversification or “geo-diversification”. There have been some researches (like this one) to prove that long-term geo-diversifications usually outperform local market portfolios.

With the fast pace of technology and access to information, all that it may require, sometimes, to take advantage of foreign markets is just a bit of time and research.

6. Discover and Include Alternative Opportunities:

Alternative opportunities may refer to other non-traditional asset classes ranging from royalties (music or books), collectibles (such as baseball cards), peer-to-peer lending, cryptocurrencies, etc. These assets allow us to be creative with our portfolio while amassing a potentially higher return.

Due to their complex nature, it is not advisable to be “swayed” by these alternative opportunities but to invest in what you know or understand. Thus, choosing an opportunity that is linked to something you are passionate about could be a starting point to know more and discover the best options within your area of interest and level of knowledge to maximize on.

It is important to be reasonable with such investments as they are still investments with all their risks and volatility as well.

Like almost anything else, these steps or tips come with some important points to note to ensure you are on the “right path” as long as diversification of your portfolio is concerned. Here are a few of the things to keep an eye on:

Strategically Time Your Strategy:

You simply cannot time the market but you can time when to invest in what for how long, with your goals in mind.

Watch out for Commissions and Fees of Broker:

Different brokers charge different fees and commissions. While day-traders may prefer zero-commission brokers, a medium-to-long-term retail investor should also consider both fees and service quality.

Avoid Not Diversifying Enough:

Do not assume you’re diversifying when in reality you’re not. Critically monitoring your portfolio concerning market movements (whether they move along the path of the market or not) is important than just investing in a group of shares or indexes with no proper correlation.

Avoid Over-diversifying:

Just like not diversifying enough, over diversifying also poses some challenges. Loading a portfolio with so many assets, especially those with similar risk profiles can be detrimental to your investments.

Ensure Balanced Investments Always: 

There will be times when your balanced portfolio may need some “rebalancing”. It is not wrong to go through your portfolio quarterly and/or reassess and rebalance your assets yearly to correct imbalances going forward.

It is undoubtedly true that diversity of portfolios is much recommended due to its upsides. However, it may require some proven strategies such as discussed above to ensure the reaping of all benefits there is in a diversified portfolio.