What Is a Diversified Portfolio?
June 2, 2022
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You've likely heard the term, 'don't put all your eggs in one basket.' This quote is especially important when you're investing. Portfolio diversification can lower your investment risk and increase your chances of reaching your desired returns.
But what is a diversified portfolio, and how do you create one?
Keep reading to learn more.
What Is a Diversified Portfolio?
A diversified portfolio is a portfolio with investments from different asset classes. In other words, you don't put all of your money into just stocks or just bonds. Instead, include mutual funds, exchange-traded funds, and a bond or two.
If you didn't diversify, you'd either risk your entire investment if you put everything in stocks or have minimal returns if you put everything in bonds or other fixed-income securities.
Instead, if you diversify your investments, you create a balanced portfolio with different investments that react differently to market volatility rather than focusing on one asset class.
Diversified portfolios may include stocks, bond funds, money market funds, CDs, treasury securities, high yield bonds, foreign stocks, real estate, and many other asset classes.
Why Is Diversification Important?
If you were to put all your money into the stock market, for example, and the stock market crashed, what do you think would happen?
You'd lose almost everything, right?
It would be like starting from scratch because your investment portfolio hit rock bottom. Now, if you invested some money in the stock market, some in bond funds, and some in other fixed income securities, you'd offset the risk of a total loss when the market crashed because stocks and bonds often react opposite in a market downturn.
When you wonder what is the purpose of a diversified portfolio, this is it. You reduce risk and increase your chances of having positive returns.
The key to portfolio diversification is to balance your investments. Unfortunately, there isn't a one-size-fits-all way to build a diversified portfolio. Building a diversified portfolio that's right for you depends on your risk tolerance, timelines, and financial goals.
For example, are you investing for retirement or something much sooner? Do you have a high or low-risk tolerance? The answers to those questions help you discover the right diversification strategy.
Risk Vs Reward
When creating your investment strategy, consider the risk vs reward. Don't just focus on the investment's potential, but also on the risk it poses. Look at the worst-case scenario. Look at inflation. What could you lose if the investment fell apart?
This will help you choose investments from different asset classes, avoiding investing all your funds in correlated investments that, if the market had a downturn, would cause you to lose everything.
Most investors want assets with high potential in their own portfolio, but considering the risk too will help many investors reach their financial goals.
Foreign Vs Domestic
You might consider only investing in domestic asset classes. It's what you know and are familiar with, but looking outside the U.S. assets can help with diversification and asset allocation.
Foreign stocks and bonds typically aren't correlated with domestic stocks and bonds. This helps reduce the risk of a total loss when domestic investments perform poorly. For example, if you have money invested in US assets, along with assets overseas, chances are the two economies won't react the same way, allowing one economy's positive performance to offset the other economy's downfall.
Short-Term Vs Long-Term
Including a combination of short-term and long-term asset classes in your portfolio can increase diversification and reduce the risk of a total loss.
Long-term asset classes typically yield a higher return (there's never a guarantee), but they also have higher risks. Conversely, short-term assets have much lower risk, but also lower rewards.
Creating an asset allocation that combines short-term and long-term assets may help increase your chances of reaching your financial goals.
Passive Vs Active
Including a mix of passive and active investments in your portfolio is a key to creating a well-diversified portfolio.
Passive investments mimic a specific index. For example, a fund manager doesn't buy and sell assets throughout the asset's term. Instead, the asset includes a basket of assets that make up an index, such as the S&P 500.
On the other hand, active investments are actively managed by a fund manager. The manager buys and sells funds to keep up with the portfolio's asset allocation.
Active investments have more fees but can be good 'insurance' when the market falls as they perform better than passive investments when the market falls. As you look for the right investments, look closely at a mutual fund or even an exchange-traded fund since they can be both actively and passively managed.
Including a combination of asset classes can help create a well-diversified portfolio. Traditional asset classes, such as stocks and bonds, are common in portfolios, but looking at their correlation is important.
Investing too heavily in assets that react similarly in down markets won't help. Instead, focus on diversifying your portfolio with assets that have different reactions to market volatility.
For decades, the recommended way to build a diversified portfolio was to invest 60% of your capital in stocks and 40% in fixed income securities, such as bonds. Unfortunately, this advice is somewhat outdated because of the stretched valuation of many of the S&P 500's largest stocks, namely Facebook, Microsoft, Amazon, Apple, Netflix, and Google.
While it can be a good idea to stretch your capital out over stocks and bonds, it's also a good idea to include alternative asset classes to offset the risk of over-investing in the stock market should it crash.
Traditionally, portfolio diversification recommendations suggest investors put 60% of their capital in stocks. This is because stocks are more aggressive, so they have higher rewards. Of course, the risk was also higher since, as we've all seen, the stock market can crash in the blink of an eye.
40% Fixed-Income Investments
To offset the risk of the stock market crashing, many investors included fixed-income assets in their portfolios. This included investments such as government bonds, corporate bonds, money markets, and CDs.
Fixed-income investments have a much lower risk and offer smaller rewards. Keeping a smaller portion of your portfolio in fixed income assets helps balance it without sacrificing the higher returns stocks may offer.
Pros of a Diversified Portfolio
Understanding the diversification benefits may help you create a more diversified portfolio with higher and lower risk investments to help you reach your goals.
So what are the pros of a diversified portfolio?
For starters, you'll offset the risk of a total loss. When the market has a downturn, you don't face the risk of a complete loss. No one wants to think of that risk, so creating asset allocations that make sense, given your risk tolerance, makes sense.
You might also expose yourself to more markets than you would if you didn't diversify. If you focus on one investment in one industry, you put almost everything at risk. Say, for example, you invested only in tech stocks like Facebook. What happens when Facebook is in hot water and its stock falls? You lose everything, right? When you diversify, you put your investment dollars in different investments with different returns.
A well-diversified portfolio also crosses geographic boundaries. For example, including foreign markets in your asset allocation will lower your risk and broaden your horizons, spreading your capital across many industries.
Cons of a Diversified Portfolio
Like any personal finance strategy, there are downsides to diversified portfolios too. These downsides aren't meant to convince you not to invest in various asset classes, but to make you aware of the downsides.
It's possible to over diversify your portfolio. You might offset your risk, which is great, but you might also diminish your returns, making it harder to reach your financial goals.
Over diversifying your portfolio can also get expensive. Buying and selling investments can incur fees, which eat at your returns, making it hard to earn a profit.
Do You Need a Minimum Amount to Invest?
Not all investment platforms have a minimum amount of money you must invest. If you don't have a lot of capital to invest, don't let that stop you from investing. Many robo-advisors, for example, require as little as $1 to invest.
Of course, the more money you have to invest, the higher your chances of a positive return when you diversify your portfolio well, but there's never a guarantee. The key is to invest as early as possible, even if you only invest a small amount of capital.
How Do I Determine Risk Tolerance?
Determining your risk tolerance requires a little soul searching. Your risk tolerance considers factors such as your age, the timeline of your financial goals, your financial goals, and your comfort level.
As you consider your risk tolerance, think about why you are investing. Is it for a short-term goal or something more long-term, like retirement? The closer you are to your goal, the fewer risks you can take and vice versa.
As you consider your risk tolerance, though, make sure you're aware of what might keep you up at night. Don't take risks you are uncomfortable with, and that won't allow you to have some financial peace of mind.
How Can Diversification Help Reduce the Impact of Market Volatility?
Diversification allows you to invest in higher-risk assets without taking too many chances. In other words, it will enable you to be aggressive, knowing you invested in at least one asset class that will offset the risk of more aggressive investments.
You can't control market volatility, but you can control the portfolio you create to offset the risks.
If you wonder what is a diversified portfolio, it's time to learn the tricks to creating a portfolio that meets your risk tolerance. Even if you have a high-risk tolerance, offsetting your investments with lower-risk investments is the best way to ensure your asset allocation and returns remain at a level you're comfortable with no matter what happens to the market. Learn more by signing up and visiting our blog.
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