Ready to begin constructing a diverse portfolio? Here are four diversification strategies to assist you get started.
1. Determine your risk tolerance
Your risk tolerance is the amount of money you are prepared to lose in the near term for potential long-term gains. There are a number of factors that may alter your risk level. These include:
When it comes to investing, some people prefer term deposits or certificates of deposit (CODs). Others feel that certain bonds are too risky for their situation. Term investors want to know the length of time they will have access to their money. And what is considered a safe investment? The former may be more willing than the latter to take on greater risk in order to preserve principal and conserving income at retirement.
Income requirements: If you’re still working, you might choose to invest in higher-risk, growth-oriented assets. However, if you’ve already retired, you may wish to concentrate on lower-risk assets that can generate a consistent stream of income, such as bonds, dividend stocks, and CDs.
Your risk tolerance is based on your desired portfolio return, the amount of money you’re willing to lose in a short period of time and/or the amount that you can afford to lose.
Your risk tolerance should determine the investments you choose. Those with a high tolerance for risk may invest a substantial amount of their portfolios in equities. For investors with lower risk tolerance levels, the percentage of bond and cash holdings will generally be greater.
What’s the best way to assess your risk tolerance? Many investing brokerages and robo-advisor services provide free risk assessment tools. Some of them will even give asset allocation recommendations based on your responses. You can also collaborate with a financial advisor or money manager to develop a portfolio that is tailored to your specific risk tolerance.
2. Take advantage of mutual funds and ETFs
Once you’ve determined your risk tolerance, it’s time to begin buying the investments that will comprise your portfolio. And it’s at this stage of the game that baskets of securities such as mutual funds and exchange-traded funds (ETFs) can really come in handy.
Let’s assume you want an asset allocation of 70% equities, 25% bonds, and 5% cash. To achieve a diversified portfolio with that asset allocation, you’d need to buy hundreds (at the very least) of stocks and bonds. You’d also want to be sure you were investing in firms of various sizes, industries, and regions for your stock portfolio.
Even if you had enough cash to invest in a diverse range of equities, corporate bonds, and other securities, how would you go about selecting your own investments? Most non-professional investors simply don’t have the time to do this kind of analysis.
You can eliminate most of these difficulties by investing in mutual funds and ETFs. Funds allow you to invest in hundreds or thousands of equities, bonds, or alternative investments at the same time using little cash (diversifying your portfolio may be expensive). Some mutual funds even provide a pre-designed combination of stocks and bonds to meet all of your asset allocation needs as a “one-stop shop” for all your asset allocation requirements.
3. Consider moving beyond stocks and bonds
When financial experts speak about asset allocation, they’re usually talking about your stock-to-bond ratio. However, it’s worth noting that both these assets are quite heavily invested in businesses.
To improve your diversification, you may want to consider adding different asset classes to your portfolio. You could, for example, invest in raw materials by purchasing shares in a commodity mutual fund.
A real estate investment trust (REIT) is a type of mutual fund that invests in commercial properties. The appeal of REITs, as well as the risks and rewards associated with investing in them, are discussed in greater detail below. If you want to get more exposure to real estate, consider investing in a real estate investment trust (REIT). Other alternative asset classes worth exploring include private equity, collectibles (such as postage stamps, art, or antiques), cryptocurrency , and hedge funds.
4. Regularly reevaluate your asset allocation
How can you tell when you’ve diversified well enough? Diversification is a constantly evolving process that changes as your time horizon shrinks.
Some experts advise subtracting your age from 110 to 120 to determine your ideal asset allocation for your age. The percentage of your portfolio that should be in equities is the result.
The 30-year rule of thumb is that 80% to 90% of your portfolio should be in equities, with the rest in bonds and/or cash equivalents. However, an 80-year old would reduce his or her stock holdings to about 50 percent.
These figures are only estimates, and your own ideal ratio will depend on your unique financial situation and investment demands.
Even if your portfolio is perfectly suited to your age and requirements, it may become out of line when some assets outperform others. That’s why keeping an eye on your portfolio and rebalancing the original asset mix whenever necessary is crucial.
Investing is a game of risks and rewards. You could lose a lot of money if you take on too much risk, especially in the short term. You may damage your long-term returns if you take on too little danger (for example, by just investing in cash equivalents).
Diversification is the greatest method for investors to strike a balance between risk and profit. Consider your risk tolerance, time horizon, and investing goals when constructing a diversified portfolio that works for you.