A well diversified investment portfolio is essential to successful investing. With it comes many benefits both short term and long term, as well as peace of mind that your risk is properly managed with a thought out plan to diversify.
What does it mean to diversify your portfolio? How do you diversify your investments? And what are the benefits of diversifying your portfolio? We'll cover these all to common questions and show you a path to a well diversified investment portfolio.
Definition of a Diversified Investment Portfolio
A diversified portfolio means having a variety of investments in your overall portfolio with the objective of lowering your risks of exposure to just one investment, company, industry, or investment vehicle. You may be familiar with the phrase “don't put all your eggs in one basket.”
By spreading out your portfolio among a mix of different investment companies, industries and vehicles, you eliminate the risk of losing all your money because one investment fails. While one of your investments may be performing poorly, the others may be doing well, making up for the performance of the one (or many), with the hope being that the overall result is a positive return on investment
Other helpful definitions of diversification are the following:
Investopedia.com: “Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk.”
TheBalance.com: “A diversified investment is a portfolio of various assets that earns the highest return for the least risk. A typical diversified portfolio has a mixture of stocks, fixed income, and commodities.”
How To Diversify Your Investments
When all is said and done, diversifying your portfolio may look a little different for each person as each of us are in different stages of our life. A well diversified investment portfolio will generally consist of a mix of different investment vehicles such as stocks, bonds, real estate, commodities, etc.
Then, within each of those investment vehicles will be a mix of different types of investments. For stocks, it would be a mix of different industries, companies and company sizes (small cap, medium cap, large cap companies).
Lastly, investing in both domestic companies and international companies further diversifies your portfolio to ensure it's not subject to the performance of just one country's economy.
Planning to diversify your investments consists of a few short steps:
- Review your current risk exposure
- Determine your investment time frames and acceptable risk tolerance
- Include a mix of investments that meet your risk tolerance
- Update and re-balance regularly
Step one may not be applicable to everyone, as some may be just getting started investing. If this is the case, then skip to step two to determine your time frames and acceptable risk tolerance. Here are the steps in greater detail…
1. Review your current risk exposure
If you're already invested, take a look at your total portfolio and the percentages that are allocated to different investment types, companies and geographical locations. An example of this might be:
- 5% bonds
- 85% stocks
- Small-cap 15%
- Mid-cap 30%
- Large-cap 40%
- 10% real estate
You should do the same within each investment type to determine the industries, company sizes, locations etc. as well.
2. Determine your time frames and risk tolerance
What is the ultimate objective of your invested money? Is it your retirement savings, savings for a wedding, a college education fund for your children, etc.? How soon will you need the money that is to be invested?
A lot can happen in just a few years time. Think back to recent market declines, and how long they lasted. Generally, most market recessions don't last much longer than a few years. Why is this important? Because if you need your money in a relatively short period of time, and you decide to invest it in the market just before a market downturn, you will most likely lose money because you need the funds before it has a chance to return it's investment growth.
Time frames that are under 12 – 24 months should (in most cases) not be invested, but rather saved in a regular interest bearing savings account at your local bank.
If your time frame is longer than 24 months, your ultimate risk exposure will be based on both your tolerance level to risk, and your exact time frame in which you will need your funds. The shorter the time frame that you will need the money, the more conservative your investments should be. The more averse to risk you are, the more conservative you will want to plan your investments.
3. Include a mix of investments
Based on your risk tolerance and time horizon, you can now determine an appropriate allocation of investments for your portfolio. Here is an example of different investment types and their respective measure of risk:
- Small-cap stocks: Aggressive
- Mid-cap stocks: Moderate
- Large-cap stocks: Conservative
- Most bonds: Conservative
- Real Estate: Moderate
Taking the same example from step one of a current portfolio allocation, and assuming they wish to lower their overall risk tolerance, they might adjust their portfolio as shown below:
Using the guidelines from step two to determine your overall risk tolerance, determine what percentages to allocate to each investment. For those who want a passive approach to investing, and aren't sure what stocks to include in your portfolio, you can use Exchange Traded Funds (ETFs), which are a basket of stocks or bonds that meet a certain objective.
For example, you can pick an ETF comprised of just small-cap, mid-cap, or large-cap companies. You can also purchase ETFs for bonds and even real estate if you prefer. This approach is recommended for new investors or investors who prefer a passive approach to managing their portfolio.
4. Update and re-balance your portfolio regularly
As the different markets fluctuate based on different economic conditions, your percentages for each allocation will naturally change as well. Re-balancing your portfolio means adjusting your portfolio back to their original allocation percentages. Re-balancing your portfolio can be done as often as quarterly, semi-annually or annually.
Benefits of Diversifying Your Portfolio
It's no question that diversifying your investment portfolio can help you achieve the best rate of return at the lowest possible risk. Some of the most common benefits of diversifying your portfolio are:
- Peace of mind that your investments are well spread out and thus, no one investment failure will eliminate your total portfolio.
- Long term consistent performance based on your target risk tolerance. Moderate returns compounded for many years is much more preferential to great returns for just one year.
- Potentially less volatility
- Capture the positive performance among multiple industries and investments