Investment Diversification: Why You Shouldn’t Put All Your Eggs into One Basket
Investment diversification is the act of spreading out your assets across a wide range of different categories. By having a portfolio that incorporates multiple industries and businesses, it’s easier to handle the market volatility that occurs. You won’t have a single asset that influences your net worth balance.
Whether you do the investing work yourself or bring someone in to provide some help, it’s important to look at asset class diversification first. Three categories are here to consider.
- Cash and Cash Equivalents. This money is what you keep in your savings account, wallet, or somewhere safe. It helps buffer unexpected costs that sometimes arise while giving you an option to invest somewhere if an opportunity develops.1
- Bonds and Fixed Income. Investments in this category pay interest to those who lend money, often to the government or a company.2
- Stocks and Equities. This choice allows investors to own a piece of a company. They provide higher long-term gains for many, but they tend to have the most volatility when the economy cools.3
You can also diversify your investments by looking at commodities, real estate, and other alternatives.
Diversifying within an Asset Class Is Necessary
Investing all your assets into one asset class is essentially the same as putting your cash into the same business. If the economy grows in ways that support that industry, you could expand your net worth quickly.
The risk is that the volatility can also cause you to lose almost everything.
That’s why diversification with asset classes is also necessary when structuring investments to protect your portfolio.
When investing in stocks, you’d want to consider the style, market capitalization, and market sector when adding companies to your portfolio. Some sectors are cyclical, while others move with different economic cycles.
Mixing more prominent companies with smaller businesses lets you weather an economic downturn while still having some growth potential.
If you add bonds to your portfolio, you’d want to look at three critical areas before choosing one as an investment.
- Issuer Type. You can choose from corporate, municipal, government bonds, and more. It helps to pull from different categories when diversification is the priority.4
- Maturity. Long-term bonds have higher returns because they come with more risk. Short-term bonds take the opposite approach, using a lower return for less risk. Blending these into a portfolio with some of an intermediate length helps with your wealth-building stream.5
- Credit Quality. Treasury bonds are virtually risk-free, which means the return rate is very conservative. Bonds with other creditworthiness limits present varied risks, delivering a different return to manage.6
It also helps to allocate funds to active and passive management. It’s not unusual for passive funds to outperform active ones during a market upswing, but active funds provide a better downside to protect your portfolio. Diversification works hard to reduce risks from your investments, but it cannot eliminate them. Building a portfolio that incorporates multiple assets and industries provides the most protection.
What Are the Best Ways to Diversify My Portfolio?
The easiest way to achieve a diversified portfolio is to look for asset classes with negative or low correlations. When one moves upward, the other moves down to counteract the financial activity.
The simplest way to access the benefits of diversification is to include mutual funds or ETFs. You just need to be aware of potential hidden costs and fees.
Many investors tend to stick to familiar options or local businesses. If you think bigger and go global with your investments, it’s much easier to spread the risk while increasing opportunities to grow the portfolio’s value.
Another strategy is to use dollar-cost averaging. This approach smooths out the various valleys and peaks that form with market volatility. By investing the same amount of money over time, you’ll buy more shares when the prices are low and fewer when they’re high.
It can be a viable strategy to buy and hold investments, especially with dollar-cost averaging. Staying current with the overall marketing conditions will let you know if it’s the right time to buy or sell. Knowing what actions a company takes will make it easier to tell if it’s time to cut your losses and move on – or buy big.
Investing is an informative and educational process that delivers multiple rewards. If you take a disciplined approach through diversification to keep growing your portfolio, you may find that investing is a rewarding process even during difficult market conditions.
Without diversification, you’re gambling with your financial future. Take steps today to lessen those risks.1. https://www.accountingtools.com/articles/what-are-cash-and-cash-equivalents.html