The basic concept behind investment diversification is simple: Don’t put all your eggs in one basket. If you invest all your money in one company’s stock, you may profit immensely if that business takes off. However, if that company files for bankruptcy, you may lose everything you invested.
Portfolio diversification extends this line of thinking further. Investing in different industries, countries, and assets helps create balance and financial stability. While investors may miss out on potential windfalls from overinvesting in big winners, diversification is designed to protect against long-term losses.
But what is the best way to diversify portfolios? This post covers investment diversification strategies for beginners, including what to look for and which asset types to consider.
Portfolio Diversification Basics
Diversification may sound like an advanced investment strategy, but it’s something even beginners should prioritize. The overarching goal of portfolio diversification is risk management. You want to protect yourself from not only what happens at any given company, but also what happens in certain industries, sectors, and countries.
The following are common portfolio diversification methods:
- Purchasing a wide variety of stocks: Stocks allow investors to own a tiny portion of a company, earning money when it does well but losing money when it does poorly. Investing in around 15 to 30 companies across several industries helps spread out risk.
- Optimizing the stocks and bonds balance: Stocks (shares in a company) may generate higher returns but tend to be more volatile. Bonds (loans from investors) often yield lower returns for the promise of more financial stability. Diverse portfolios include a balance of stocks and bonds.
- Investing in quick diversification products: Investors who prefer not to research stocks themselves may consider index funds and ETFs (exchange-traded funds). These allow you to buy shares in a single fund that follows a market benchmark (such as the S&P 500 Index) and contains hundreds or thousands of stocks and bonds.
Developing a Successful Diversification Strategy
Now that you know what investment diversification looks like, what are the key elements of a successful diversification strategy?
- Assessing risk tolerance and financial goals: Many diverse portfolios combine investments with different risk levels, but it’s also important to consider your personal risk tolerance, goals, and timeline. For example, do you have short-term goals you can meet with conservative asset allocation or long-term goals you can afford to take more risks with?
- Seeking distinct investments: Correlated investments move together under certain market conditions, while distinct investments move independently. Truly balanced portfolios are unlikely to have assets that all perform well — or poorly — at the same time.
- Regularly rebalancing portfolios: While chasing hot stocks isn’t a sound investment strategy, neither is allowing your portfolio to stagnate. Smart investors actively monitor and adjust their investments as financial goals and market conditions change.
Finding the best way to diversify portfolios involves understanding the fundamentals of diversification and applying them to your unique financial situation.
How Dollar Cost Averaging Helps Diversify Investments
Once you’ve decided to build your portfolio and earmark an investment amount, you may be tempted to spend it all at once. However, doing so ties you to current prices — for better or for worse.
“For worse” means you may enter the market at a bad price. Because markets are volatile, prices constantly go up and down. However, dollar-cost averaging spreads out your investment, aiming to reduce the impact of price fluctuations and achieve a favorable price over time.
Dollar-cost averaging is easy for beginning investors to implement. You simply decide on an investment timeframe and invest a fixed dollar amount on a specific schedule regardless of price. For example, if your investment period is one year, you may invest $125 monthly for a total of $1,500.
Fixed-Income Assets for Diversification
Fixed-income assets pay set interest or dividends until they mature. Upon maturity, investors get back the amount they invested (the “principal”). Common fixed-income products include corporate and municipal bonds, treasury notes, certificates of deposit (CDs), and bond-focused ETFs.
Unlike variable-income assets, fixed-income securities offer investors predictable earnings. While they tend to have lower overall returns, they are less volatile and may mitigate the impact of bad investment years. Investors can use fixed-income assets to diversify the risk profile of their portfolios.
Real Estate Investments for Diversification
Real estate allows investors to move beyond traditional stocks and bonds into a new class of asset — one that is tangible, has intrinsic value, and can generate a steady income stream. Importantly, real estate is often less correlated with public markets than other major asset types.
This means it can help balance out stock investments, especially in bear markets (periods of prolonged decline). For example, most tenants continue to rent their homes and apartments even during nationwide economic recessions.
Commodities (Including Precious Metals) for Diversification
Commodities are raw materials used to create consumer products. They include agricultural goods like wheat and corn, energy products like gas and oil, and precious metals like gold and silver. They are useful for portfolio diversification because they have a low or negative correlation to other asset classes on average.
Unlike most other investments, commodities benefit from rising inflation. As the price of goods goes up, so does the price of raw materials. On the downside, commodities are fairly volatile because of supply and demand. (Although some commodities, like gold, are more stable.) However, because commodities act as a hedge against inflation, they are an important part of any diverse portfolio.
Alternative Investments for Diversification
The final asset class to consider when seeking one of the best ways to diversify portfolios is alternative investments. These do not fall into the traditional categories of stocks, bonds, and cash. Instead, they encompass a broad range of investments, including hedge funds, private equity, venture capital, art and antiques, fine wines, and cryptocurrencies.
Many alternative investments lack the regulation of traditional asset classes. Meaning they can be more prone to fraud, harder to sell, and often have additional fees. However, they also have the potential for steady and even higher returns than conventional investments. Their low correlation with stock and bond markets makes them useful for portfolio diversification.
Best Practices for Portfolio Diversification
In summary, the following practices can help in the quest to diversify a portfolio:
- Balance asset types: A diversified portfolio combines stocks, bonds, and alternative investments (e.g., commodities and real estate). This balance minimizes vulnerability to market volatility and overall portfolio risk.
- Invest across sectors: Spreading out your sector and industry exposure is also essential for diversification. A single regulatory change or material shortage could tank your investments if you invest in only one industry.
- Invest across countries: Geographic diversification can help you take advantage of economic growth in different regions while mitigating the volatility of domestic markets.
While no asset class or investment strategy guarantees a profit, diversification reduces the vulnerabilities of overly concentrated portfolios.
Portfolio Diversification Pitfalls To Avoid
While seeking the best way to diversify portfolios, here are some common mistakes to avoid:
- Over-diversifying investments: There can be too much of a good thing. Excessive diversification makes it difficult to manage your portfolio and may even cut into potential returns.
- Underestimating asset correlations: Even if you own different asset types, your portfolio isn’t truly diversified if they’re correlated. Perhaps seek out asset classes that move in different directions in various market conditions.
- Ignoring other factors: Diversification is important, but it’s not the only key to a successful portfolio. Considering factors like growth potential, financial goals, transaction fees, and potential risks can help you make the right investments.
Diversification: The Key to a Resilient Investment Portfolio
So, what is the best way to diversify portfolios? By choosing a mix of investments that reaches across asset classes, industry sectors, and geographic locations to mitigate risk and promote long-term growth.
Keep in mind that diversification for the sake of it isn’t enough. Make sure to consider your financial goals, risk tolerance, and investment timeline to develop a diversification plan that works for you.