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Portfolio diversification is one of the main strategies used by investors around the world to smooth earnings and reduce risks.
It consists of investing in different financial assets, at least two – different not only by category, but also by different historical levels of volatility and by industry or sector – in order to obtain a varied portfolio, which can also be rebalanced over time according to the needs and financial goals of investors.
In this guide, we will explain how to diversify your portfolio, as well as different asset classes, an explanation of risks and returns and, in general, all the steps needed to diversify a portfolio, monitor and rebalance it.
Understanding Portfolio Diversification
“Don’t put all your eggs in one basket”: this is the assumption behind portfolio diversification.
On the other hand, an investor like Warren Buffett often says that risks come from not knowing what you’re doing.
So, is diversifying your portfolio good or bad? Generally speaking, it is a good practice if you:
- Want to reduce risks – especially if you don’t have enough time or the skills to time the market;
- Get access to different financial markets;
- Monitor the level of volatility of your portfolio.
The fact that investors choose assets from different classes and industries doesn’t imply that they don’t have to do proper analysis — and here comes Warren Buffett: fundamental analysis helps you understand what assets can be valuable over time, and this search for value should always be applied to portfolio building and diversification. Technical analysis can help you understand what might be the best time to enter or exit the market.
This also means that investors who diversify need to spend time to understand markets and asset classes — they might not spend the same amount of time spent by speculators or day traders, but they have to learn, too.
So, diversification won’t work if it’s done “blindly”.
The Building Blocks of a Diversified Portfolio
Let’s understand asset classes, first:
- Stocks: they represent shares of publicly traded companies. They’re the most common components of diversified portfolios, since they usually provide returns by lowering risks – as long as stocks are issued by valuable companies under a fundamental perspective.
- Bonds: they are debt instruments usually issued by governments and large companies. They’re considered the less risky assets in a diversified portfolio, so their role is to reduce the overall risk of your investments.
- Real Estate Investments: Real estate is historically considered a safe and solid long-term investment when compared to other asset classes in a diversified portfolio. But it requires a lot of knowledge, since it’s particularly prone to macroeconomic changes.
- Commodities: This type of investment is usually a tool to fight inflation, so commodities are usually added to a portfolio in order to reflect macroeconomic changes that affect the purchasing power of people.
- Cash and Cash Equivalents: These types of assets usually give relatively lower returns when compared to the other asset classes we are mentioning, but their low volatility spreads stability across the portfolio.
Now that we analyzed the most common asset classes, let’s see how diversification can also involve different types of financial instruments within the same class.
Diversification Within Asset Classes
As mentioned, assets are not diversified only by asset classes. Take stocks as an example: they can pertain to different industries or sectors, and each of them reacts differently to market and global economic changes.
Moreover, companies that operate in different countries can have different reactions to global changes. Every country, and finally the globe, go across market cycles, but this doesn’t mean that these cycles are synchronized: a recession in the United States doesn’t necessarily affect Europe in the short run, but if an investor has only U.S. stocks, then there’s not enough diversification to mitigate the risk of a crash.
The same occurs for other asset classes, like bonds: even if they’re considered as safe investments, within this asset class there are subcategories, like high-yield bonds, issued by entities with low credit ratings – that’s why they’re high-yield, since the entity wants to compensate the high level of risk associated with this type of financial instrument, and that’s why they’re also known as “junk bonds”.
Understanding Risk and Return
Investment risks don’t only involve the reliability of a government or entity, but also macroeconomic risks — we mentioned inflation.
In any case, risks refer to the level of probability to incur in a loss.
Diversification has the main purpose of reducing the risks associated with the whole portfolio, but it is important to note that not all investors want to reduce risks – even if, in this case, it might be more correct to consider them as speculators.
This occurs because usually high risk is associated with higher returns. Let’s get back to our example about junk bonds: entities that issue them, as well as investors, are perfectly conscious of the risk, and that’s why the entity gives higher earnings to investors, something they expect to receive since they’re “betting” on the entity.
So, risk management in portfolio diversification is strictly related to the financial goals and skills of the investor.
The Role of Age and Time Horizon in Diversification
Time plays a pivotal role in investing.
Time horizon – which can be defined as the time you expect to keep your investment – might influence possible returns, especially when you invest in instruments that compound interest.
Moreover, an investment kept on a long-term basis is less prone to periodic market fluctuations, since it’s more probable that the price of the long-term asset will go through entire market cycles.
Age also influences investment decisions: young investors are usually more willing to take additional risks, while older investors tend to be more conservative — also because they usually have different income and financial goals.
This doesn’t mean that all investors follow the same path: the type of investments and time horizon depend on the financial goals and risk tolerance of each investor.
Using Mutual Funds and ETFs for Diversification
Investing in mutual funds and ETFs (Exchange Traded Funds) it’s like having a diversified financial instrument in a diversified portfolio.
The additional layer of diversification is given by the fact that mutual funds and ETFs are made up of different assets, but they’re traded as if they were single stocks or financial products.
While mutual funds are managed by investment companies that collect funds from many investors and then reinvest that capital, giving investors profits in line with the shares of the mutual fund they own — whose price is calculated at the end of the trading day, ETFs can be constantly traded during the day (as it happens with stocks or similar financial instruments).
Also in this case, selecting an instrument instead of another depends on the financial goals of the investors.
Incorporating Alternative Investments
So far, we’ve talked about financial instruments that be considered as traditional, but there are also alternative types of investments that can give access to completely different markets and types of management:
- Private Equity: this type of investment is similar to stock investing, but it occurs with companies that are not publicly listed or that have been delisted.
- Hedge Funds: these funds, similarly to mutual funds, collect capital from a pool of investors to reinvest it, but the construction of portfolios and the very management involves more complex strategies and techniques.
- Real Estate Investment Trusts (REITs): these are investments based on the real estate industry, but investors don’t need to own physical properties – only financial instruments based on them.
- Collectibles: usually they’re represented by rare or unique items, including pieces of art or NFTs (non-fungible tokens).
- Cryptocurrencies: digital currencies based on blockchain technology.
Even if this type of investment could add further diversification, investors should consider that they are usually more complex to understand and are less liquid than traditional assets.
Rebalancing Your Portfolio
Since all the assets included in your diversified portfolio can change price over time, it is important to monitor portfolios to understand if they keep following your financial goals and risk tolerance over time.
When your portfolio is no longer in line with your needs, you can choose to rebalance it by buying or selling assets.
Investors use different strategies to rebalance their portfolios:
- Rebalancing According to Allocation – they buy and sell assets to always respect the initial allocations they set for their portfolios. To give you a practical example, let’s say that you decided to invest your portfolios in stocks (50%), bonds (30%) and cryptocurrencies (20%). Over twelve months, prices change and your portfolio is suddenly totally different: stocks (45%), bonds (20%) and cryptocurrencies (35%): investors who use this type of strategy will buy and sell the different assets in order to get back to the initial allocation. This strategy can help you to have more discipline, but doesn’t leave room for flexibility.
- Investors can monitor and rebalance their portfolio on a time basis (for instance, by buying assets at specific intervals). This type of strategy might maybe give you the best average prices for your assets over time, but it doesn’t allow you to be flexible enough and to immediately intervene in cases of market changes.
- Investors can also rebalance their portfolios according to significant market changes – independently from time. This might be an effective strategy, but it requires more time and analytical skills.
Monitoring Your Diversified Portfolio
As mentioned, before rebalancing comes monitoring. As assets and markets can change over time, investors need to monitor their portfolios – on a time basis or according to market changes – to understand if they’re still in line with their risk tolerance and financial goals, in order to decide if it’s the case to take any measure.
There might be particular signs that your portfolio needs rebalancing, like losses that exceed your risk tolerance, too unbalanced allocations that wouldn’t help you cope with volatility, significant or sudden market changes or macroeconomic changes.
Diversifying portfolios – and understanding how you can diversify your portfolio – is an important skill in investing, since it can help to reduce overall risk.
Investors use different strategies to diversify portfolios, and they often consider rebalancing – according to different methods.
In this article, we covered all the different methods and strategies, as well as the role of financial goals, risks, and the importance of time in investing and choosing assets. In spite of the different methods you choose as an inverter, they have in common the fact that, in any case, knowledge and discipline are key points to design plans and strategies.
How often should I rebalance my portfolio?
It depends on your financial goals and the time you can spend monitoring your portfolio. There are different strategies that can be used: time-based rebalancing, rebalancing according to significant market changes, rebalancing when the initial allocation of each instrument changes.
Can a portfolio be too diversified?
The answer to this question lies in your goals and expertise. As portfolios become more complex and diversified, they require more time to be managed, rebalanced and analyzed. Moreover, further analysis is required if diversification involves many industries or sectors, in order to understand any possible change that can affect the price of the financial instruments you invested in.
How do I diversify my portfolio if I don’t have much money?
There are different paths for investors who don’t have large capitals. For instance, choosing less instruments can be a solution, as well as investing in derivatives or instruments that allow for fractional investing. In this case, a pivotal role is also played by the broker you choose, because you should understand if it requires large minimum deposits or requires high fees and commissions.
Does diversification guarantee against loss?
No. As mentioned, diversification alone doesn’t reduce risk: if the portfolio is not properly built or managed, diversification doesn’t work.
What is the role of international investments in portfolio diversification?
Investing in global markets can represent a hedge against macroeconomic factors that can differently influence markets in different regions of the world. This allows for further diversification and risk management.
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