Diversification can be achieved by combining assets that move in the opposite direction, which means those assets react to the same economic event differently. A typical diversified portfolio has stocks, fixed income, and commodities mixed. Read on to discover what is a diversified portfolio and how it works.
What is a Diversified Portfolio?
The assets don’t correlate with each other within a diversified portfolio. When one’s value rises, the other’s value falls. It lowers overall risk because it will benefit some asset classes, no matter what the economy does. It compensates for losses on other assets. Risk is reduced since it is rare that any single event would wipe out the entire portfolio. A diversified portfolio is your best defense against a financial crisis.
How Does Diversification Work?
Stocks are doing well as the economy grows. Investors want maximum returns, so they bid up stock prices. Because they are optimistic about the future, they are willing to accept a greater risk of a downturn.
Bonds and other securities with a fixed income do well when the economy slows. Investors are more interested in taking a downturn to protect their holdings. They’re prepared to accept lower returns for that risk reduction.
Commodities are playing a very important role within your portfolio. Traditionally, the price of precious metals such as gold rises in times of crisis. Prices of commodities such as wheat or oil fluctuate with supply and demand. For example, if there is a drought that limits the supply, wheat prices would rise. Oil prices would fall if supplementary supply existed. As a result, commodities do not as closely follow the phases of the business cycle as stocks and bonds.
What is the Purpose of Portfolio Diversification?
The main goal of portfolio diversification is to minimize the risk to your investments, particularly unsystematic risk.
Unsystematic risk — is a risk related to a particular company or market segment. It is the risk that you hope to reduce by diversifying your portfolio. In this way, not all your investments would be uniformly affected by market events in the same way.
How Do You Diversify Your Portfolio?
Diversification of portfolios is key to investment and is crucial for better risk management. Diversification has many benefits. However, this must be done with caution. Here’s how you can diversify your portfolio effectively:
1- Spread Out Your Investments: The attractiveness of investing in equities lies in their higher return, making them a powerful tool to grow wealth, but that doesn’t mean you will have to put all your wealth in stocks. The same applies to your investment in other assets, such as fixed income, mutual funds, or gold.
You could, for example, invest in six stocks. But if all of a sudden, the market takes a tumble, you could have a problem. This problem is compounded if the stocks belong to the same sector as the manufacturing sector. It is because any news item or information that affects one manufacturing stock’s performance could impact other stocks in some way or another.
So, even if you choose the same asset, you can diversify by investing in different industries and sectors.
2- Explore Other Investment Avenues: You can also add additional investment options and assets to your portfolio. Mutual funds, bonds, real estate, and pension schemes are other investments that you can consider. Also, ensure that securities vary in risk and follow different market trends.
It has generally been observed that the bond and equity markets have contrasting movements. By investing in both of these avenues, you can offset any negative results in one market by positive movements in the other. That way, you can make sure that you’re not in a losing situation.
3- Consider Index Funds: A sound diversification strategy, adding index funds to the mix, gives your portfolio much-needed stability. Investment in Index Funds is also very cost-effective, as the charges are relatively low compared to actively managed funds.
You can diversify your portfolio by investing in stocks and bond index funds simultaneously; it will protect your portfolio from market volatility and uncertainty and prevents gains from being wiped out during market volatility. If you are worried about what exposure should be to each asset class, consider investing in automated platforms such as Wealthface. Wealthface offers you a diversified portfolio of top-performing global ETFs with pre-set proportions of equities, fixed income, real estate, and commodities, rebalanced for free every quarter.
4- Keep Building Your Portfolio: This is another strategy for portfolio diversification. You need to keep building your portfolio by investing in different asset classes, spread across equities, debt, and fixed-return instruments. Adopting this approach helps to make your ride more volatile.
5- Know When to Get Out: Diversification of portfolios also means knowing when you need to exit your investment. If the asset class you have been investing in has not been up to the mark for a long time, and if there have been any changes in its basic structure that do not align with your goals and risk appetite, then you must exit.
6- Keep an Eye on Commissions: It’s another crucial thing to watch out for. If you take a professional’s services, check out the fees you pay instead of your services.
It is essential because, in the end, commissions can take a toll on the final returns. A high commission can eat away at your winnings.
Finally, diversification doesn’t mean you have no losses to face. It’s still possible to lose some money after all of the processes when you invest. It is not possible to eliminate risk, after all. Diversification, however, helps you lower the risk of market losses to the minimum. Try finding the right balance between risk and return, so you can earn good returns without constantly worrying about your portfolio.