If there is one universal factor that applies to all stock markets around the world, it is the fact that they are inherently unstable. There are many reasons why a stock’s value can go up or down, but as a newbie in the market, you have to be extra prepared for the ride ahead. Diversifying your portfolio is one way to do that!
What exactly is diversification?
As a beginner in the stock world, the term might sound foreign to you. Regardless if you’re aware of the meaning of diversification or not, this investment strategy is beneficial for both seasoned and beginner investors alike due to its many advantages on investor’s portfolios.
In an ever-changing stock market where fluctuations in stock prices are bound to happen, this strategy can help tamper potential losses by blending a wide variety of investments within the same portfolio and investing in different asset classes like stocks, bonds, and cryptocurrencies.
However, it shouldn’t be employed right when the market wobbles. Instead, diversification is a process that needs to be implemented from the get-go to help achieve the most desirable results. Note that the bounties of this strategy are not limited to warding off losses, for it can also optimize returns!
Read on to learn more about this investment strategy and its importance for all kinds of investors.
Is diversification a new concept?
Not at all. The practice of spreading your investments or implementing certain steps to diversify investments in order to maintain exposure to different assets is not a new concept. Although the essence remained the same, the pillars of diversification as a method to portfolio risk management have evolved with the years and new additions to markets.
Diversification started out a millennium ago. Records show that it was implemented in old civilizations, with proof showcasing that about 4,000 years ago, merchants from ancient Mesopotamia spread their risks across business partnerships.
In this day and age, diversification began shaping up in the 1970s, but was limited to the two most common asset classes, i.e. equities and bonds. As time went on, more asset classes emerged and diversification evolved to its modern form that takes into consideration Factor Investing and Cryptocurrencies, among many other things.
Why is diversification important for beginners?
For starters, beginners who diversify their portfolios can better take control of their emotions if they implement diversification because they know that they are protecting their overall portfolio from potential losses.
Even though the strategy of diversifying your portfolio is crucial to all types of investors, beginners in the field need diversification the most because diversification is basically a risk management strategy that gives them a much-needed shoulder to rely on if the condition is unfavorable.
As we mentioned earlier, diversification helps temper potential losses for seasoned, high-net-worth, and beginner investors by preventing you and others from putting all your eggs in one basket. Basically, owning various amounts of each asset allows you to end up with the weighted average of the returns of those assets.
Not implementing diversification might have dire consequences. For example, in the context of the pandemic where markets struggled, investing only in popular stocks would have led you to missing out on other types of investments like treasury bonds, which would have tampered the market losses at that time.
Now, let’s get to the tips that beginners can apply before attempting to know how to diversify their stock portfolio!
What tips should beginners follow before diversifying their portfolios?
- Comprehending factors that impact financial markets
- Doing enough research
- Leaving the comfort zone
- Rebalancing your portfolio periodically
- Knowing your financial biases
- Implementing Asset Allocation
Comprehending factors that impact financial markets
Understanding market dynamics and what affects the different markets is the first step to fully grasping the concept of diversification.
As an investor, it’s always good to be aware of the different markets that fall under the umbrella term, which include stock exchanges, foreign exchanges, bond markets, money markets, and others.
Moreover, being aware of external factors like interest rates and inflation, which influence market’s dynamics, and the monetary policies implemented by the Fed or other authorities would also help you get a much-needed surface level of understanding of what’s going on.
Doing enough research
Before any investment, it’s important to thoroughly assess your financial situation, especially if you are a beginner.
Hence, it’s advisable to learn about the sectors or companies you’re investing in when and if you’re planning to invest in stocks, along with the different asset classes that you will invest in to maintain a diversified portfolio.
After all, you’re putting your hard-earned money into these vehicles, so it’s important to do enough research.
Leaving the comfort zone
Limiting yourself to investing in the same asset class or even the same stocks that you consider “safe” will decrease your chances of higher returns. Test the waters a little and start exploring the different options in front of you.
Remember, the stock market is full of opportunities for those who have a good eye!
Keep one thing in mind, though. The tendency to stick to the same investment might prove to be harmful to your portfolio if and when the economic situation shifts.
Take into consideration this example: Investors who only focused on investing in hospitality stocks lost big time during the pandemic because of the imposed lockdown. Hence, pivoting and exploring will usually reflect positively on your portfolio, especially if you’re a newbie in the field.
Rebalancing your portfolio periodically
It is crucial to check your investment portfolio every now and then to check the balance of your different assets.
Luckily, some Robo Advisors, like Wealthface, can do that for you automatically, without your interference.
Keep in mind that it’s always good to check in with your financial advisor every now and then. Doing so will help you stay in touch with your investment goals, especially your long-term goals.
Contact your Wealthface fiduciary financial advisors here to get a solid consultation on your investment situation.
Knowing your financial biases
When starting your investing journey, you should know that it’s inevitable that there might be ideas that you grow up with that might end up influencing your decisions. Don’t underestimate the power of ideas, beliefs, or family attitudes have on your investment
Some beginners coming from high-net-worth families feel like they should always go for risky or high-return investments because of the way they see money, whereas investors who grew up in middle-class families might be more leaning to investing in “safer” options.
Implementing Asset Allocation
Although many people mistakenly believe that asset allocation and diversification are the same thing, they are actually very distinct. Understanding the two, in addition to strategic asset allocation, and how they interact is essential to building a solid investing portfolio.
The distribution of your funds among various investment kinds, some of which are riskier than others, such as stocks, bonds, cash, and other sorts of assets, is known as asset allocation. Therefore, how much risk you feel comfortable taking and when you’ll need your money should be considered while dividing up assets into different groups.
The idea of diversification expands on this idea by distributing your funds among many investment kinds within each asset class.
Implementing strategic asset allocation is also an option that some investors resort to. It’s the method of managing a portfolio where the investor establishes target allocations for different asset classes and rebalances the portfolio on a regular basis.
The target allocations are determined by things like the investor’s investing goals, time horizon, and risk tolerance.
When the initial allocations considerably depart from the initial settings as a result of different results, the portfolio is rebalanced.
Is it possible to over diversify a portfolio?
Absolutely. If adding a new investment to a portfolio increases its total risk and/or reduces its predicted return, the diversification goals may not be achieved (without lowering the risk appropriately). This “over-diversification” is more likely to happen when a portfolio contains the appropriate number of stocks or when you add securities that are closely connected.
How can I decide my portfolio risk level?
Since we made the whole investing process very easy with Wealthface, we also took care of calculating portfolio risk level for you. After answering a series of questions about yourself, we’ll suggest the risk level that best suits your goals and conditions. Then we’ll take care of the rest, we might denote you a portfolio that suits your investments and goals.
Take a detour and read about the minimum variance portfolio here: https://wealthface.com/blog/minimum-variance-portfolio/
Is diversification done manually?
With Wealthface, it’s not!
This is because we automatically rebalance and diversify your portfolio to suit the market conditions and changes.
Keep in mind that we don’t just diversify your portfolio to provide extra protection, we also take it a step further and utilize the low-volatility factor, which shields investors from downsides and protects their money without neglecting the benefits when the market gets better. (Note that when markets end up rising, we also apply redistribution)
Diversification can lower risk, but it cannot completely remove it. The risk of holding an excessive amount of a single stock, such as Tesla, or stocks in general, as compared to other investments, is decreased by diversification.
It does not, however, eliminate market risk, which refers to the risk involved with even having that kind of asset. Hence, investors, do keep that in mind!