There are several reasons you should diversify your investments. Investment diversification is a crucial aspect of financial planning since it’s the primary tool for lowering your risk and maximizing your return.
Beginners may be tempted to think that it’ll be a good idea to invest in securities since they offer the highest yield. However, it’s been proven time and again that such a strategy will make you vulnerable to stock market risks, and significant losses may offset your short-term gains.
You’ll need a better strategy for more stable returns. You can achieve this if you diversify your investments.
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Here are the reasons you should diversify your investments:
If you invest all of your money in one company’s shares and it goes bankrupt, you’ll lose all of your cash. By spreading your investments across different companies and different investment classes, you can minimize the effects of catastrophic failures.
You Can Invest According to Your Risk Appetite
Risk appetite refers to the level of risk that an individual or entity will face. Helped by diversification, you can invest your money across different asset classes according to your risk strategy.
There are three main investment classes:
- Stocks – These offer the highest return but also pose the most considerable risk.
- Bonds – The performance is modest while the risk is moderate.
- Cash Alternatives – The performance is the lowest, but this is the safest investment class.
Investors also consider other categories such as real estate and commodities besides these main classes.
You can analyze the risk/return characteristics of each class and make your investments accordingly.
You really shouldn’t invest all your money in stocks. Their high rate of return is tempting, but the risk is high. Similarly, you can’t depend on cash alternatives alone since they offer the lowest performance even though they are the safest.
The best idea is to spread, or diversify, your investments across all asset categories. This way you can optimize the risk and return characteristics of your investment portfolio. Your portfolio will then offer a reasonable rate of return at the level of risk acceptable to you.
You may even want to change your portfolio according to your lifestyle. For instance, when approaching retirement, you may divert your money from risky shares to relatively safer bonds.
Further Diversification within Asset Classes
You can even diversify within asset classes to further optimize your levels of risk and return. For instance, you can invest in stocks according to the:
- Company size (large, medium, or small)
- Market type (international, local, or regional)
- Industry (finance, technology, engineering, manufacturing, pharmaceutical, and others)
Investment experts agree that diversification is not a guarantee against losses, but it can mitigate risks, reduce losses, and improve your portfolio performance.
Therefore, diversification is a prudent investment strategy that can yield several benefits over the long term.
There are several theories which explain why diversification is effective. The simplest explanation is that through diversification, you can spread your investments across several industries and sectors not related to each other.
This means you have invested in industries/sectors that have little or no effect on each other. So if one area goes down, the remaining segments in your portfolio will be mostly unaffected, and they will continue to provide a reasonable return.
This matches what we see in real life. While some industries are having a tough time, others are thriving. So if you don’t keep all your eggs in one basket, the overall performance of your portfolio will be more consistent.
However, there is one limitation of diversification you must understand. No amount of diversification can protect against systematic risk.
There are two types of risks: systematic and unsystematic. Unsystematic risk is associated with individual stocks, and it’s unique to a specific industry or organization. Systematic risk applies to the entire market and is also known as ‘market risk.’ Not only is systematic risk highly unpredictable, but it’s also challenging to avoid in its entirety.
Systematic risk arises from factors that pose an inherent threat to all companies and markets like interest rates, war, political instability, exchange rate fluctuations, and inflation.
Here is an excellent example of why you should diversify your investment.
Suppose a portfolio comprises only of airline shares. If airline pilots declare that they are launching an indefinite strike, then this will lead to canceled flights with subsequent losses in the value of airline shares. Your portfolio will suffer a massive decline.
Had you diversified by balancing your airline shares with shares from other industries, then only one part of your portfolio would have been affected. If you had invested in railroad stocks for example, then these would have sharply risen since people might use railways as an alternative to airlines.
This is one of the primary benefits of diversification. Risks are not only mitigated, but if one industry goes down, some other sector will probably rise.
Railways and airlines have a strong correlation according to statisticians since both share a lot of common risks. For instance, a steep rise in the price of oil would mean that the costs of both airline and railway tickets will increase. Due to shared risk, they will suffer a decline in share value.
So it’s much better to diversify your investment across sectors not correlated with each other.
You can also diversify by investing in different asset classes rather than just industries. By investing across various asset classes, you can take advantage of low correlations and that some asset classes move in opposite directions.
For instance, bonds and equities usually move in opposite directions. This means that if the equity market falls then the bond market will rise. So if the shares in your portfolio are hit by a sharp plunge in the stock market, your bonds will likely increase in value. Hence, a diversified portfolio can offset losses for more consistent performance.
Stocks can offer an excellent rate of return, but the risk level is also high, so you must diversify your stock investments according to different company types, markets, and sectors.
You know that you should not put all your eggs in one basket. This idea applies the most to investments. Hence diversification is the primary strategy of virtually all financial experts and investors.
Unfortunately, it’s easier said than done. While it’s better to diversify across different categories, you must also have good knowledge about markets, companies, and sectors to make the right investment decisions.
With greater diversification, you must also put in more considerable effort to follow your equities. So if you have made investments across two dozen companies, then you must also follow the performance of these companies and monitor their market conditions. The effort increases with greater diversification.
Hardly anyone has the time or energy to follow so many stocks.
Mutual funds are a great way of diversifying investments. Since these funds are managed professionally by financial experts, you are spared the burden of following your investments. Mutual funds are a good option for retirement planning.
Here are further steps you can take to diversify your investments:
Use Bond or Index Funds
You can improve performance and diversify your portfolio by using fixed income funds or index funds. Invest in securities that follow different indexes. This is an effective way of investing with a high level of diversification.
By using fixed income securities, you are protecting your portfolio against sporadic market performance and uncertainty. These funds attempt to follow the performance of a broad array of indexes so they can reflect the value of the bond market. This is better than making investments in a particular sector.
The advantage of these funds is that they have low fees so you can keep most of the money you earn through them. These funds can be operated with minimal operating and management costs.
Keep Adding to Your Portfolio
Regularly make additions to your portfolio. You can use dollar-cost averaging to counter the effects of market volatility. Under this strategy, you can invest your money over an extended period to reduce the risk of investment.
Using dollar-cost averaging, you can invest your resources into a specific securities portfolio regularly. With the help of this strategy, you’ll purchase more securities when their prices go down and fewer securities when their value rises.
Understand When to Exit
Dollar-cost averaging and buying and holding are good strategies. But this doesn’t mean you can leave your shares on auto-pilot and become oblivious to what is happening to the companies you have invested in. You must know when to sell your stocks to save your portfolio against losses.
For this, carefully follow market conditions and track the performance of the companies whose securities you have purchased. If you keep track of company performances, you’ll know when to curtail your losses, sell your stocks and move on to better investments.
Keep Track of Commissions
Compare the return on investment to the fees you have to pay. Some firms charge transactional fees while others charge monthly fees. The aggregate fees can have a significant impact on the bottom line.
Be aware that the cheapest may not always be the best–you get what you pay for. For higher amounts, you must follow the returns with more in-depth scrutiny to determine if the fee is worth it.
Also, keep track of changes in fees.
Ally Invest offers one of the lowest trading costs and TD Ameritrade allows you access to both self-directed trading and professional portfolio management. Read our Ally Invest Review here and our TD Ameritrade review here.
Use a Robo Advisor
Probably the easiest method of diversification is by using a robo advisor. Robo advisors will create a pre-built portfolio for you based on your risk appetite, and auto-diversify and rebalance your portfolio for you. The downside is that most robo advisors don’t let you pick the individual funds for your portfolio.
You do have options though,Betterment is the original and a great robo-advisor for beginners with no account minimums. Wealthfront offers low-cost robo investing, a high interest savings account and a financial planning feature–also perfect for anyone new to investing.
- Betterment Review – The Original Robo Advisor
- Wealthfront Review – Low Cost Robo Investing and Financial Planning
You can also choose a more unique robo advisor and customized your own portfolio with M1 Finance. There’s even a robo advisor designed for women with a female-focused approach and advice. It’s called Ellevest and if you’re curious how this platform works, you should read our full review where we discuss why gender-neutral investing can be an issue and how Ellevest can alleviate this.
Any of the above robo advisors are solid options. We advise reading our reviews of each to find the one that’s a perfect match for your investing needs and goals.
To gain all the benefits of diversification, you must also invest in asset classes beyond just stocks.
Bonds are useful for achieving better diversification since they have low correlation with stocks which are the riskiest asset class. Bonds also have a low correlation to other risky asset classes. Bonds work by providing a fixed rate of return through financial instruments such as certificates of deposits, bankers’ acceptances and treasury bills.
Real estate is another important asset class which has a relatively low correlation with equities. Real estate investment is a convenient means of diversifying portfolio since many people have already made investments in the real estate market through their own homes.
Although directly purchasing property is a perfect way of entering the real estate market, there are other more convenient ways to make investments in this crucial sector.
Real estate investment trusts (REITs) are investment vehicles which you can use if you do not want to purchase the property directly. REITs can be sold just like equities on different exchanges, and they can be used for investments in property and mortgages. The primary advantage of REITs is that they offer good yields to investors besides high liquidity.
By investing in REITs, investors can lower risk because the property market is not directly affected by the inherent risk of the stock market. REITs are a great investment tool for high diversification.
Fundrise is an online platform that allows small investors to invest in eREITS. You can choose between four portfolio types with different rates of returns, risks, and terms of investment.
Read More: Real Estate Crowdfunding with Fundrise
Streitwise is a real estate investment trust (REIT), not a real estate crowdfunding platform. That means you don’t need to be an accredited investor to participate (unless you invest more than 10% of your net worth or your income in the REIT). You can invest in the REIT with as little as $1,000, and earn both annual dividends and future capital appreciation. The trust is currently paying an annual dividend of 8% to 9%, net of investment expenses. And unlike real estate crowdfunding platforms, they have a redemption option that will allow you to recover at least 90% of your investment after as little as one year.
Another option is RealtyMogul. Through this platform, you can choose to invest in REITs or if you are an accredited investor, you can invest directly in a property. Most of the investments have low minimums allowing you to get started with as little as $1,000.
What if you want to own a rental property but you don’t have time to hire a realtor or visit a ton of different properties to find the right one? Then we suggest Roofstock–where you can buy a single-family home and begin collecting cash from tenants immediately as Roofstock’s properties are already rented out. You don’t have to be an accredited investor and Roofstock is free to join.
Read More: Roofstock Review
Compare: Roofstock vs. Fundrise
Already an accredited investor? Consider PeerStreet–here investors buy notes that represent slivers of whole loans sourced from existing private real estate lenders. The benefit with PeerStreet is the ability to invest in a large number of loans with relatively little money.
A key aspect of diversification is asset allocation. There are so many investment options to choose from such as mutual funds, bonds and stocks it can be a confusing scenario even for experienced investors.
Asset allocation refers to the mix of mutual funds, bonds, and stocks in your portfolio. This is a technique much better than just picking stocks. Not only can it help you to build wealth, but it can also help you to fund a comfortable retirement.
Asset allocation aims to balance risk levels by spreading out investments over different asset categories like derivatives, real estate, stocks, bonds, and cash. Since these asset categories have their own distinctive pattern of risk and return, they will perform differently regarding time.
So while the value of one asset category decreases, there may be no effect on another asset category. Another asset category also might rise as a consequence. This mixed movement will lead to stable portfolio performance over the passing time.
Some critics point out that asset allocation is not the perfect recipe for maximizing returns. Asset allocation mitigates risks, and this is the best protection for investors if something goes wrong in one asset class.
Many financial professionals consider asset allocation to be the most essential step in financial planning. According to these experts, investments in company-specific bonds, shares, and other financial instruments should come after proper asset allocation.
Although there is no simple formula for asset allocation a few general rules can help you to understand the concept better:
Risk and Return
Everyone wants assets that provide the highest levels of returns. Stocks fit this category, but they also suffer from the highest level of risk. The tumultuous financial crashes of 1929, 1987 and 2009 are painful reminders that investment in stocks alone is not the best financial strategy.
Those who properly analyze the relative levels of risk and return are far more likely to enjoy higher returns compared to those that only invest in stocks.
Investors Should Not Rely on Planner Sheets and Financial Software Alone
Financial software and planner sheets are designed by financial experts to provide benefits to investors, but they can’t be relied upon as the sole means of financial planning.
These tools make the use of specific formulas. For instance, according to one favored method, to determine the percentage of cash that should be allocated to equities, investors should subtract their age from 100.
So if you are 35 years old, then you should invest 65% of your cash in equities while the remaining 35% should go towards bonds, real estate, and foreign exchange. More recent versions of this formula allow you to subtract your age from 110 and even 120.
Such formulas don’t consider important factors such as your social status, number of dependents and health issues. These factors can have significant consequences for your investment decisions.
Such financial formulas are basically beneficial to financial companies that market such software because they sell well since they are so simple to use. But they are not optimal for your financial success.
You can use such software as an approximate guide, but you should not rely solely on these formulas.
Make a List of Your Long Term and Short Term Objectives
We all have financial goals we would love to achieve such as a lavish retirement fund, prime real estate, money for children’s college and more. These goals should be included in your financial plan. This will help you to decide the right asset allocation so you can achieve your goals.
For instance, if your goal is to own a seafront condo by retirement which will come in 20 years, you’ll not have to be too concerned about short term variations that the stock market will face.
These are some reasons and different ways you can diversify your investments. In my opinion, you shouldn’t be investing without diversification. By understanding the importance of diversifying, and how to do it, you’ll better set yourself up for long term financial success.