Do you have a nest egg that you want to invest in? Or perhaps it’s already invested, and you want to get better results.
Investing can be challenging. We understand that. While you can gain money and increase your assets, there’s also an inherent risk of loss.
Diversifying your assets is one way to manage your portfolio and minimize your risk. Diversification is a powerful and commonly used strategy that spreads risk across multiple assets to limit your exposure to any one asset.
In this article, you’ll learn what diversification is, why it’s important, and how to use it to improve your portfolio.
What is Diversification?
Diversification is the process of investing your money across a broad range of assets, so your money isn’t all in one basket. Having your money in one asset class tends to increase your risk exposure.
Assets in the same class tend to move in the same direction. For example, large-cap American stocks tend to increase and decline simultaneously. The same is true for small-cap stocks and even bonds.
If you have all your money tied up in one asset class, you are at risk of declines in your portfolio every time that asset class experiences a decline.
With diversification, you spread those assets across multiple asset classes. You may have money in stocks, bonds, cash, and more. While one asset class may decline in a given year, not all of them will. Your losses in some asset classes will be offset by others.
Diversification levels the gains and losses from year to year and helps you achieve more consistent, less volatile returns.
Tips to Diversify Your Portfolio
Ready to diversify your portfolio?
The following tips can help you diversify your portfolio, so check them out.
1. Understand Your Risk Tolerance
Diversification starts with risk tolerance. Your risk tolerance is your ability to withstand risk at any given point in time.
Everyone’s risk tolerance is unique based on their goals, needs, time horizon, and feelings about money and loss. Some people can tolerate a great deal of risk and are willing to lose money if it means they could make more money. Others have very little tolerance and have a difficult time with risk and loss.
Only you know your own risk tolerance. If you don’t need the money for many years, you may be able to withstand more risk than someone who needs it soon. However, your risk tolerance should be based on your specific feelings about money and the potential of losing it.
2. Spread the Money Among Stocks, Bonds, and Cash
Once you know your risk tolerance, you can create a basic allocation among the three main asset groups: stocks, bonds, and cash.
Generally, the higher your tolerance for risk, the more money you will allocate to stocks. Historically, stocks provide the highest potential for return but also have the greatest risk of loss. You can make and lose money with bonds, but generally not with the same level of volatility you find in stocks. Cash is a stable asset that does not usually move up or down.
Based on your goals and risk tolerance, develop the appropriate mix between stock, bonds, and cash. This is a good starting point for a broad level of diversification.
3. Diversify Into More Specific Asset Classes
Diversifying across stocks, bonds, and cash is helpful, but that’s just the first level of diversification. There is a variety of subclasses in each of those asset groups.
For example, in stocks, you have large-cap American stocks, which are large companies that most people are familiar with. But there are also mid-cap stocks, small-cap stocks, and even micro-cap stocks. There are international stocks from developed countries and stocks from emerging markets.
You can even invest in stocks by industry. For example, you could buy an index of healthcare stocks or tech stocks. You can get as niche and specific as you want.
There are also sub-classes in bonds. For example, there are corporate bonds and government bonds of varying durations. There are municipal bonds, foreign government bonds, and more. Again, like with stocks, you can get as specific and as niche as you want in the bond market.
4. Rebalance and Dollar-Cost Average
Once you establish your allocation and diversify your assets, the next step is maintaining that allocation. Believe it or not, it’s easy for your portfolio to get out of balance. Some assets go up in value while others decline. Before long, your allocation could be incorrect.
You can fix this with something called rebalancing. When you rebalance, you sell some assets that have gone up in value and buy those that have gone down to get your allocation back to its correct levels. This helps you maintain control of your portfolio and allows you to capture gains, potentially boosting your return.
Another strategy to help you maximize returns and maintain your diversified allocation is dollar-cost-averaging. This is the process of regularly adding money to your portfolio.
When you add the money it is automatically diversified across your portfolio according to your specifications. When values are up, you buy fewer shares, and when values are down, you buy more shares, lowering your effective cost. That can also help you boost your returns.
5. Adjust Your Diversification and Allocation Over Time
The final piece of diversification is to monitor your portfolio and adjust it as needed over time. Your goals and needs won’t stay the same forever. Your portfolio shouldn’t stay the same, either.
Many people become more conservative as they get older and approach retirement. This makes sense since, as you get older, you have less time until you need to use the money. You may not have time to recover from a significant loss.
If you feel like your portfolio is riskier than you would like, it may mean your risk tolerance has changed. That’s completely normal. Simply adjust your allocation, so it better aligns with your goals and needs.
6. In a Nutshell
Diversification effectively takes the peaks and valleys out of investing and creates more predictable and certain returns. It’s not a guaranteed strategy, but it can help. If you’re unsure of how to diversify your portfolio, talk to a financial professional.
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