We all need a safety net, whether it’s a seatbelt while driving, a safety harness while mountain climbing, or a spare parachute while skydiving. These keep you safe in potentially dangerous situations. Portfolio diversification can be the safety net for your investments by reducing the risk along your financial journey.
The simple definition of diversification is “the act of, or the result of, achieving variety.” For your portfolio, this means purposefully acquiring several varieties of assets. Diversification is a portfolio management strategy used by investors to decrease risk factors. Many strategists suggest never having more than 25% of your wealth in one investment to achieve true diversity.
So why use the portfolio diversification plan for risk management?
The aim is to lower the volatility of your assets because not all mutual funds, individual stocks, real estate, and industries move together. Owning various asset classes can severely diminish unsystematic risk. If there is a decrease in petroleum revenue across the industry, there is a market risk for petroleum worth to plummet. If you only owned investments in petroleum, you would be at greater risk of financial trouble.
What practitioners of portfolio diversification have found is that different types of investments fluctuate at different times. Investors who use this style tend to see fewer losses while confronting bear markets and more capital to utilize in bull markets.
There are several different ways to do this to your portfolio.
Think beyond the United States. Too often investors get comfortable with U.S. markets and don’t allow themselves the chance to explore global opportunities. The global market offers many similarities to U.S. holdings with individual stocks, mutual funds, and index funds. As the international market becomes more competitive, so too will the global market. As the maturity of these markets rises, their investment risk will decrease. By investing in overseas assets, you’re immediately diversifying your holdings in a meaningful way.
Mutual Funds and ETFs
A common way to create variance among your investments is with mutual funds or exchange-traded funds (ETFs). These are funds that contain several different types of holdings lumped together. When you are investing in this type of asset, the key to keeping your portfolio diversity is making sure you don’t buy funds within the same criteria (large-cap, small-cap, and so on). You’ll want to invest in funds associated with non-related sectors if possible. Investing in global mutual funds similar to domestic funds would still be diversifying, since what happens in the German market doesn’t necessarily correlate to the U.S. market.
There are several ways to invest in the real estate market. There’s the more traditional methods of purchasing a property and flipping it for a profit or purchasing with the intent to rent. Holding real estate over time can also build equity in the property. Within the last two decades, we’ve seen a rise in Airbnb style rentals as well, although many investors would prefer to have more of a hands-off approach. Publicly traded real Estate companies have also become more popular in recent years. Having a portion of your finances in real estate has traditionally been a solid investment.
With almost any choice you make in your life, particularly when dealing with your finances, seek advice from a professional. They’ll offer insights and perspectives on your financial portfolio that you might not have considered. They’ll discuss what your current situation is, the type of risk you want to take with your finances, and the best way to realize your financial goals. Additionally, their understanding and interpretations of the markets are not your own. Merely by consulting them, you’ve opened up the potential for your portfolio to become more diversified.
Ultimately, a diversified portfolio takes into account most of the above components. Use these to advance your financial goals and attain new and different investments.