How to diversify your portfolio
Fortunately, there is a way of structuring your portfolio so it is not overly exposed to any particular bad event. That method is called “diversification” and it is one of the most important concepts in the field of investing.
Diversification is a word used in finance to describe the process of allocating your capital to reduce risk and get more stable returns. It means you aren't too exposed in one area so you don't lose all of your money if an investment fails.
Diversification has a simple rationale: on average, an investment portfolio containing many types of assets will provide greater returns and represent a lower risk than any one investment can offer within the portfolio.
Every financial market has some element of risk. If you invest all of your money in stocks, you run the danger of losing it all if the market falls. The same holds true for real estate, commodities, currencies, and any other investment. However, markets rarely fall at the same moment or in the same way.
You diversify your portfolio by investing in a variety of asset classes, such as stocks, real estate, and bonds. Then you diversify within each asset class by choosing different options. When you buy stocks, for example, you're investing in a variety of industries, such as financials, mining, infrastructure, and energy. You may also diversify your portfolio by investing in a variety of fund managers and product issuers.
So how do you get the benefits of diversification? We explain below.
How to diversify your portfolio
Step 1: Examine your holdings
Make a list of all of your investments and their current values. This might involve the following:
- managed funds
- an investment property
- your home
- your superannuation
This will show you the asset classes you're already investing in, as well as where you could diversify.
It is important for your portfolio to contain multiple different investments, including some from the following list.
- Managed funds
Step 2: Diversify within each asset class
Consider investments with varying rates of return.
When buying individual stocks, this gets more difficult because you'll need to invest a significant amount in each to make the cost of trading worthwhile. For instance, you don't want to spend $10 on a small stock purchase. You will want to invest a larger sum in each transaction so that you can reduce the fees per dollar invested. However, if you only have a small total sum to invest, this can result in having a small number of stocks in your portfolio, and unacceptable risk.
So when investing in stocks, for instance, consider buying different stocks in different sectors. It’s also essential to have stocks with mixed sources of income, growth potential and different market capitalisation among other metrics. When investing in things like bonds, consider bonds with different credit qualities, duration, and maturities.
Choose from a variety of investment options with varying rates of return.
Stocks with mixed-income, growth, and market capitalisation, among other criteria, are also crucial. Consider bonds with various credit quality, durations, and maturities before investing in bonds.
Step 3: Think about assets with different levels of risk
When diversifying your portfolio, consider buying investments with varying rates of return to improve the chances that big profits in some investments will offset losses in others.
Remember that, while the goal is to reduce risk, you aren't limited to blue-chip stocks.
Step 4: Make sure you rebalance your portfolio on a regular basis
Diversification is not a one-time activity, contrary to common opinion. When the risk level in your portfolio isn't in line with your financial objectives or strategy, you should review it frequently and make changes as needed.
What kinds of things should you include in your portfolio?
A well-balanced portfolio should comprise the following items:
Purchasing shares allows you to own a stake in a firm, which has advantages such as dividend distributions and capital gains if the stock price rises over time. It is generally accepted that domestic equities should make up a significant portion of most investing portfolios.
Mutual funds and Exchange-Traded Funds (ETFs)
Buying ETFs, index funds, or mutual funds is a simple method to achieve diversification. ETFs and mutual funds work as a basket of many equities, allowing you to diversify your portfolio instantly. They trade in different ways, so you'll want to learn all about them before investing, but they're a great way to diversify without being too confusing.
Index funds invest in a portfolio that aims to replicate the returns of a certain index, such as the S&P/ASX 200 Index. Along with internal diversification, one advantage of these funds is that they usually have low fees. The fees are low because of the low cost per unit of administering these funds.
Funds for specific industries
Sector funds, as the name implies, are investment funds that concentrate on specific economic sectors or segments. Including sector funds in your portfolio provides you with distinct investing options across economic cycles.
Real Estate Investment Trust (A-REITS)
Real estate funds, which include real estate investment trusts, provide inflation protection in investment portfolios. The funds also present you with unique real estate options, such as huge commercial, industrial, and retails assets, that you wouldn't be able to get on your own.
Bonds provide a steady stream of income in the form of interest coupon payments. They are less volatile than stocks, so they offer a useful "cushion" during violent stock market moves.
For an investor who is more concerned with the safety of their investment than with growth, bonds should make up a large component of their portfolio. It's worth emphasising, though, that in most circumstances, bonds offer lower long-term returns than stocks. Certain bonds, however, provide the prospect of higher yields. Residential-Mortgage-Backed Securities (RMBS) are one type of bond to examine.
RMBS bonds are secured against a pool of hundreds or even thousands of prime Australian residential mortgages and auto loans and earn their income from loan repayments. They do not contain mortgages over any construction or development properties.
Due to their large size, RMBS are usually available only to institutional investors, but the Firstmac High Livez fund gives access for just $10,000 and more money can be invested in $1,000 increments if and when you want to.
High Livez pays distributions monthly. For more information, see here.
Investing in the short term
Short-term deposits (cash) which provides stability and simple access to assets, are typically included in a balanced portfolio.
To safeguard your portfolio against local stock market "shocks," overseas equities are often used. Because they have exposure to diverse possibilities in other regions of the world, stocks issued by Australian corporations perform differently than those issued by non-Australian companies.
Is it possible to diversify a portfolio too much?
Yes. If adding a new investment to a portfolio increases total risk and/or decreases projected return (without decreasing risk proportionately).
Investing can and should be a pleasurable experience. It has the potential to be interesting and enjoyable. Even in the worst of circumstances, investing can be lucrative if you use a disciplined strategy and employ diversification. As always, make sure you seek advice from an independent investment professional before committing to any investments.