How to Diversify Your Investment Portfolio in 2023
May 22, 2022
Investing is essential to reaching your financial goals, but it's also crucial to diversify your investment portfolio. Without diversification, you put yourself at high risk of a total loss and not meeting your financial goals.
While portfolio diversification sounds complicated, it's actually quite simple when you break it down, as you just need to have different types of investments in your portfolio. Here's what you must know.
What Is a Portfolio?
A portfolio is a collection of all the assets you own. They don't have to be with one broker or in one type of asset. For example, your portfolio might include stocks, bonds, real estate investment trusts, rental properties, and commodities.
No two portfolios are the same, but it's important to have a diversified portfolio to ensure you meet your personal finance goals.
Diversify Portfolio Meaning
A well-diversified portfolio contains complementary asset classes. In other words, you don't put all your eggs in one basket. Instead, you invest in different investments that react to market news and the economy differently.
When you diversify your portfolio, you lower the risk of a total loss even if the economy falls apart. When one investment performs poorly, another may stay stable or even increase in value. When you diversify your investment portfolio, you're able to take advantage of market volatility, investing in some 'risky' investments while keeping it 'safe' with other investments.
Portfolio Risk: How It's Measured
It's often hard to pinpoint the exact risk of any investment strategy, but portfolio risk is measured using the standard deviation of its returns. The further the data points are from the mean (average), the riskier the portfolio is for investors.
Reasons to Diversify Investments in Your Stock Portfolio
You might wonder why you should worry about a diversified investment portfolio. Isn't it enough to decide if you want to invest in the stock market, bond funds, real estate, or something else?
While choosing the right investments is important, even more important is diversified investment portfolios. Here's why.
Don't Put "All of Your Eggs in One Basket"
What happens if you put all your money in one basket, say technology stocks, and then the technology industry falls apart? What are you left with?
If, however, you have a diversified portfolio with some money in technology stocks, some in healthcare stocks, and some in real estate, you might not suffer such a devastating loss since your other investments might not have reacted as badly as the technology stocks.
Different Assets Behave Differently Depending on the Market
While it is important to diversify your portfolio into different industries, you should also consider different asset classes. For example, investing in the stock market is risky, but you could offset the risk by investing some of your money in bonds since they are more conservative.
If you want to diversify your portfolio even further, you could invest some money in real estate too. You don't have to be a millionaire to buy rental properties and rent them out, either. You could invest in real estate with as little as $1 on some platforms, giving you access to real estate returns and offsetting the risk of other risky investments.
Factors to Consider for Diversified Portfolios
Many investors think just throwing in a bunch of different asset classes will diversify their portfolio, and it might. But there are specific considerations you should make when diversifying your portfolio. Consider these factors in your diversification strategy, and you'll be on your way to achieving your financial goals.
Time Horizon & Liquidity
Think about your timeline. What goals have you set, and how long do you have to achieve them? For example, if you're investing for retirement, you likely have a long-term investment strategy, but if you're investing to save for a down payment on a house, that's something that's more immediate.
Liquidity is another important factor as you set your goals. Short-term investments are good if you need immediate liquidity, but if you have a longer-term goal, you could invest in longer-term investments that usually have a higher rate of return.
Markets & Industries
We touched on why your asset allocation should cross different industries, such as technology and healthcare, but don't limit yourself. Consider other markets too. For example, you could have a mixture of domestic and foreign stocks to reduce risk and give your portfolio exposure to different investments and markets.
Risks & Potential Threats
Risk tolerance is key to creating the right portfolio diversification. It is essential to know the investment risk and how it compares to your risk tolerance. Taking chances will yield higher returns, typically, but investing more aggressively than your risk level can handle will only result in more damage.
How to Diversify Your Investment Portfolio in 2022
You know diversification in investing is important, so how do you do it?
Create a Tailored Plan For Your Risk Comfort Level
Before choosing your investments, write down your financial goals, how long you have to achieve them, and the risks you can handle. Knowing this information upfront will help you choose the right investment types according to your needed liquidity and how long you have to achieve your goals.
For example, your shorter-term goals will require more conservative investments because there's not much time to make up for a loss. On the other hand, if you have a long time, you can choose more aggressive investment types and have time to ride out the losses.
Asset Allocation: Mix Stocks and Bonds
Consider putting a good mixture of stocks and bonds into your portfolio. Typically, investment goals with longer terms and higher risk tolerance have a higher percentage invested in stocks and a lower percentage in bonds. If the roles are reversed, though, you'll want a higher amount invested in bonds and a lower amount in stocks.
It's always a good idea to invest a portion of your money in fixed-income assets too. This way, you have a fixed cash flow for a predetermined time and know that you'll get your initial investment back at maturity.
Target Date Funds
Target date funds are an excellent addition to a portfolio, especially if your goal is long-term, and are set up similar to a mutual fund. Target date funds have a set date for the 'target,' and the fund manager handles the reallocation and diversification necessary to achieve that goal.
Invest in a Mix of Mutual Funds or ETFs
Mutual funds and ETFs are a good way to create a diversified portfolio. As is the case with any investment, aim to have no more than 25% of your funds invested in one asset class, though. Asset class diversification is just as important as investing in different industries. Try to have at least five different asset classes in each fund.
Evaluate and Incorporate Varying Levels of Risk
As tempting as it is to invest completely aggressively or to hold back and be entirely conservative, neither will help you achieve your goals. Instead, mix it up, investing in investments with many risks and those with a low-risk level.
Invest in Money Market Securities
To give your portfolio some liquidity and a level of conservativeness, invest in money market securities such as CDs or treasure securities. Your money will be tied up for a definitive period, but you'll have almost guaranteed returns, albeit small returns.
Regular Monitoring of Your Diversified Portfolio
Even the most diversified portfolio can have bumps in the road. Diversifying your portfolio helps offset the risk of a total loss, but anything can happen. Revisit your portfolio often and make sure it doesn't need to be rebalanced based on performance, risk tolerance changes, or changes in your personal goals.
Vary Company Size and Type of Industry
Don't get caught up in just investing in various asset classes; also, focus on different company sizes. For example, you might invest in large pharmaceutical companies and small medical care facilities within the healthcare industry. However, putting all your money in one large company or even one industry is too risky. Instead, try to buy at least 25 stocks across various industries for the most diversified portfolio.
Diversified Portfolio Example
Let's say you have $10,000 to invest. You could take it all and invest it in Target stocks because you know they're doing well, but that won't help you in the long run. With all your money invested in one stock, you have all your eggs in one basket. What if Target has a significant issue and the stock plummets? You lose everything.
Instead, you could spread the money across various asset classes and companies. For example, a portion should go into bonds and money market securities. Hence, you have some conservative investments while you could invest other money in aggressive stocks but diversify across at least 25 different stocks.
The key is to spread your money across as many industries, asset classes, and investment types as possible to achieve your financial goals.
Diversify Your Investment Portfolio FAQ
Can I Over-Diversify a Portfolio?
Over diversification is a thing, and it happens all the time. However, there needs to be a good balance between a diversified portfolio and one that went overboard. If you diversify your portfolio too much, you won't see the potential returns you could have if you kept your diversification within specific limits. Your financial advisor can help you determine how much diversification is good for you.
What Are Alternative Investments?
Alternative investments are any investments that aren't in the stock market or bonds. This doesn't make them bad. They could even be a good addition to your portfolio. Some of the most common alternative investments include real estate, debt investments, commodities, collectibles, and private equity.
How Diversified Should Your Portfolio Be?
The right portfolio diversification for you depends on your goals, age, and risk tolerance. Generally, a mix of 60% in stocks and 40% in bonds is ideal, but that's for the investor that has a long timeline. On the other hand, if your goals are shorter term, you may need a higher amount invested in bonds and a lower stock allocation.
Do You Need a Minimum Amount Invested?
There isn't a minimum amount you must invest. Any money you invest is better than nothing. Even if you think you don't have enough money to invest, investment platforms allow you to invest your spare change, so there's really no excuse not to invest.
What Are the 12 Asset Classes?
While you might invest only in stocks and bonds, here are the 12 asset classes you should consider:
- Large cap growth stocks
- Small cap growth stocks
- Large cap value stocks
- Small cap value stocks
- Short-term bonds
- Long-term bonds
- Real estate
- Foreign stocks
- Emerging markets stocks
- Fixed income securities
A well-diversified portfolio is the key to successful investing. While no one can predict what will happen to any investment, even if you look at past performance, diversifying your portfolio is the best way to ensure you offset significant losses with gains and potentially reach your financial goals. Learn more by signing up and visiting our blog.
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