Building an investment portfolio doesn’t need to be overly complicated, but we understand that it can sometimes feel impossible if you have never invested before or are unfamiliar with portfolio and investment strategies. Which investments should you consider? How much risk should you take? How can you protect yourself to make sure you don’t lose your money?
At Addition Financial, we believe that every one of our members should have the opportunity to learn about the concept and benefits of diversification in investing. Here’s what you need to know, plus five portfolio strategies to consider as you work toward your most important financial goals.
What is diversification in investing?
Diversification refers to the process of spreading your investment among different asset classes, ideally classes that react to economic changes in different ways. You have probably heard people refer to splitting their money between stocks and bonds, and that’s a classic example of diversification. Stocks and bonds respond to shifts in the economy in dissimilar ways, which means that a portfolio that contains both will be able to ride out economic changes without too much loss.
People sometimes confuse diversification with two other things that are also important in investing: asset allocation and rebalancing. Here’s a breakdown of what these things mean:
- Asset allocation refers to the process of dividing your investments into different asset classes. As a rule, you don’t want more than 10% of your portfolio to be in any one asset, so that may mean you need to sell some stock to make sure you’re not overinvested and thus at risk of losing money you can’t afford to lose.
- Diversification is the process of spreading out your investments in between and among different assets and asset classes. A diverse portfolio is a portfolio that’s likely to be able to weather financial storms and earn money in the long term.
- Rebalancing is the process of reviewing your asset allocation and diversification and selling or buying assets to hit your target numbers and make sure that your portfolio stays balanced over time.
You can see that these three things all work together and are essential to building a healthy and profitable portfolio.
How does diversification protect investors?
Diversification protects investors by splitting their investments among a variety of assets and asset classes, ideally those that are uncorrelated. If you invest in stocks that are likely to experience significant drops in value during a recession, a diversification strategy would require balancing your portfolio with a selection of bonds from a variety of sources to minimize your investment risk.
It may be helpful to look at a hypothetical situation to understand how diversification offers protection for investors.
Let’s say you wanted to build a portfolio with 70% of your investment in stocks and 30% in lower risk investments including bonds and CDs. A diversified stock portfolio might contain the following:
- Stocks from multiple companies
- Stocks from companies of different sizes, including small, medium and large-cap stocks
- Stocks from different sectors (manufacturing, healthcare, technology, finance, etc.)
- Domestic and international stocks
- Pooled investments such as exchange-traded funds (ETFs) or mutual funds
Making diversified purchases means that you won’t lose everything if, for example, a small tech company goes bankrupt or even if the tech industry takes a hit. You’ll have enough investments in other areas and types of companies that your portfolio will be able to ride out the storm.
The 30% in lower risk investments should also be diversified. Here are some examples:
- Bonds of different types, including federal, state bonds, municipal bonds or even corporate bonds
- Bonds with different credit ratings
- Certificates of deposit with staggered maturity dates
- High-interest bearing accounts
It’s important to note here that you’ll need to research pooled investments to make sure that they are also diversified. For example, you wouldn’t want to buy two ETFs that invest in the same subcategory of stock because that would put you at too much risk.
5 portfolio strategies to try
Now, let’s review five portfolio strategies that can help you to diversify your investments and manage your level of risk.
#1: Asset class diversification
The first diversification strategy to consider is asset class diversification, which may include the following:
- Equities (stocks)
- Fixed income investments (bonds)
- Cash and cash equivalents
- Commodities and/or property
- Alternative investments, including some investments (such as hedge funds, collectibles or derivatives) that may be considered speculative
The benefit of asset class diversification is that it spreads your investments across assets with varying rates of return and risk. At minimum, you should have two different asset classes in your portfolio and make sure to diversify within asset classes, as well.
#2: Correlation diversification
As we mentioned above, one of the most important ways to diversify your portfolio is to choose a mix of investments that do not correlate with one another, meaning that they respond to things like market fluctuations or inflation in different ways.
Keep in mind that while there may be stocks and bonds that do not correlate with one another, some do. An example would be high-yield bonds, which typically correlate with stocks. That means a portfolio that included only stocks and high-yield bonds would not be well diversified and might increase your risk beyond what you’re comfortable with.
#3: Diversification within asset classes
Choosing two or three asset classes for your portfolio doesn’t necessarily mean that you’ve done enough to diversify your investments. Here are some examples of asset classes where there are opportunities to diversify within the class itself:
- Industry. If you want to buy stocks, you can further diversify by spreading your investments across multiple industries, such as tech, energy, retail, manufacturing and healthcare.
- Company size. In addition to being diversified by industry, it’s also a good idea to diversify based on capitalization with a mix of small, mid and large-cap companies.
- Issuers. If you’re buying bonds, diversify by buying bonds from different issuers, with a combination of federal, state, municipal and corporate bonds.
- Maturities. Bonds come with different maturity dates that may range from six months to five years. Many investors diversify by laddering maturity dates.
- Funds. If you want to invest in ETFs or REITs, you should check each fund to make sure you don’t have too much exposure in any one segment of the stock market.
Diversifying within asset classes can help you to avoid overexposure or concentration within your portfolio, making it possible to avoid large losses.
#4: Location diversification
There’s a tendency in the United States for investors to put their money in American companies. That can be a good thing but it’s important to remember that if the United States economy is in trouble, all stocks are likely to be at least somewhat affected.
Location diversification involves investing in companies and funds that are not in the same geographical location. For example, you might want to buy stocks in some companies that are based in the European Union or in Asia or Latin America. That way, you’ll have less risk than you would if the performance of all your stocks were dependent upon strength in a single economy.
#5: Investment stage diversification
Another way to diversify your investment portfolio is to look at investment stages. As a rule, early stage investments tend to carry more risk than late state investments, so you may want to get in on some companies early and diversify by also buying some stock in companies that are more mature.
Keep in mind that each one of these diversification strategies may be used alone or in combination. The more diversified your portfolio is, the less likely it is that you’ll experience a catastrophic loss.
How can early stage investors diversify their portfolios?
To close, here are a few pointers to help early stage investors build a diversified portfolio:
- Learn about different asset classes and how they perform relative to the economy and stock market.
- Take a global approach to investing by choosing investments that go beyond the United States economy.
- Use index funds to get instant diversification. Choosing an ETF as an investment can provide diversification. The only caveat is to make sure that if you buy multiple index funds, you’ll need to make sure that you’re not over-invested in any one industry or sector.
- Go beyond stocks and bonds. Investing some of your money in cash, real estate or commodities can help you build diversification into your portfolio.
- Invest with your long-term goals in mind. As we noted above, you should have a mix of high, medium and low risk investments based on when you’ll need to access your funds.
- Use a buy-hold strategy. One of the ways that people can lose a lot of money in the stock market is by having a knee-jerk reaction to a market downturn. The overall trend of the stock market is up, so try to think of investing as a long-term strategy and hold onto your investments unless there’s a compelling reason not to.
- Rebalance your portfolio regularly. Portfolio diversification isn’t a one-and-done task. It’s an ongoing process. You should revisit your portfolio every six to 12 months and make sure that it is adequately diversified and properly balanced.
These tips can help you build and maintain a diversified portfolio that will meet your long-term earning goals.
Diversify your portfolio with Addition Financial
As you build your investment portfolio, the portfolio diversification strategies and tips we have included here can help you balance your investments and minimize your risk as you pursue your most important financial goals.
Do you need guidance with diversification in investing? Addition Financial is here to help! Click here to learn about our Financial Services program and book an appointment with a Financial Professional.
Posted on Jun 6, 2023
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