When creating an investment plan for your portfolio, diversification is the most important rule. Diversification essentially means spreading your assets among a variety of investments. Doing this helps to mitigate risk and provides the potential to improve returns. A financial advisor can help you optimize an investment strategy for your financial needs and goals.
What Is Diversification?
A diverse portfolio is one that’s made up of a mix of investments. Assets are allocated both among different types of investments, like stocks, bonds and mutual funds, and within those investment types, like large-cap and small-cap stocks in different sectors. Diverse portfolios reflect the investor’s goals and risk tolerance. They should be reassessed regularly to ensure the portfolio mix remains balanced.
How to Diversify Your Portfolio
The first step in developing a diverse portfolio is defining your investmentgoals, risk tolerance, financial situation and timeline. Figure out how much money you have to invest. Also consider how much are you hoping to earn, how soon you want to see returns and how much risk are you willing to take on. This leads to the first way you can diversify your portfolio.
1. Determine Your Ideal Asset Allocation
The answers to the questions above will help to determine your appropriate asset allocation. You’re looking to break up your investments into the right mix of risky investments and safer, more stable, investment options. This is a delicate balance that may change how you want to invest at different stages of your life.
Generally, stocks are more volatile than other types of investments, providing both a high potential for growth and a high risk of loss. Bonds or short-term investments are less risky, but their stability means slow growth.
Your timeline also factors into what investments are right for you. Because of the volatility of stocks, many experts recommend holding onto them for a long time, so your investments grow over time to mitigate losses. On the other hand, bonds and other stable investments tend to grow steadily and at a low rate and may be better for short-term investments.
Once you figure out the best investments for your situation, you must decide how you want to spread your assets among them. An example would be 60% of your portfolio in stocks and 40% in bonds.
2. Diversify Individual Asset Classes
Within your chosen asset classes you’ll likely want to diversify as well. Experts say you shouldn’t put all of your money into one stock, or even one sector. To mitigate risk and improve the possibility of growth, choose investments across a variety of areas. You may decide to diversify by market capitalization, geography and sector for stocks. For bonds, you may decide to diversify by maturities, credit qualities and durations.
The key to diversifying individual asset classes is to not invest too heavily in any one area. For example, if you’re investing 40% of your assets in bonds you may want to spread out the types (corporate or treasury) or length of time (10 or 20 years) of your bonds in order to see a continuous payout. Plus, you’ll earn different interest rates that can be counted on to balance your portfolio over time.
3. Continually Build Your Portfolio
It is difficult to see your investment account grow successfully if you invest one time, allocate your funds and then wait. Instead, you should find ways to continually add dollars to your investment account to help achieve your ideal balance with whatever is happening in the markets. Market volatility can create an imbalance in your asset allocation so investing extra dollars and utilizing the dollar-cost averaging strategy can help you keep that balance.
Additionally, building out your portfolio with more dollars gives your investment approach a stronger chance of being successful. You can determine peaks and valleys more easily and be prepared to move dollars around your portfolio so that it stays balanced, even during a downturn. Asset allocation choices will always need adjustment, whether you do it or you work with a financial advisor or brokerage to manage that for you.
Why Diversifying Your Portfolio Is Crucial
By diversifying your portfolio, you minimize the risk of your investments, as compared to putting all of your money into one asset. To build a diversified portfolio, you look for assets that haven’t historically moved in the same direction at the same time. That way, if one portion of your portfolio is in decline, the other portions are ideally growing or maintaining wealth.
A diverse portfolio’s goal is to keep your investments in balance, with gains mitigating any losses. Having a mix of investments helps to manage risk while still maintaining exposure to market growth.
Maintaining a diverse portfolio also helps you dodge the temptation of chasing well-performing investments in a market upturn and moving your money to lower-risk options in a downturn. Staying balanced within your portfolio’s diversification can lead to higher gains in the long run, as opposed to investing in the hot commodity of the moment.
How to Keep Your Portfolio Balanced
Diversification isn’t a one-time task. It’s important to keep track of your asset allocation and regularlyrebalance your portfolio. If one part of your portfolio is under-performing or over-performing, it will skew the asset allocation percentages that you decided upon. You will have to move money around to reset the balance. Generally, experts recommend rebalancing your asset mix if any part moves away from your target balance by 10%.
Periodically, you should also reassess your investment plan. As you get older, you may want to move money into less risky investments to preserve your wealth. Or you may be reaching your goals ahead of schedule or not on pace to reach them at all, and thus need to adjust. Revisit the questions you considered when setting up your plan, and be sure to adjust your asset mix appropriately if your goals or financial situation have changed.
You must also make sure to manage your taxes on your investments. It may be best to work with a financial advisor or other financial professionals who can advise you on the most tax-efficient ways to manage your portfolio and minimize losses.
The best way to achieve investment goals is by diversifying your portfolio. Make sure to invest in a mix of different types of investments and an assortment within those types as well. By diversifying your portfolio, you help mitigate risk and maximize the possibility of growth by keeping your investments balanced.
Investing Tips for Beginners
- Financial advisors have the experience and time to research and select investments for your portfolio.Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- It’s easy to focus on the gains you’ll make after selling stocks, but remember that you’ll also have to pay taxes. SmartAsset’s capital gains tax calculator can project the total capital gains taxes you’ll pay when you sell an investment. When building your portfolio, consider ways to make it as tax efficient as possible.
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Danielle Klimashousky Danielle Klimashousky is a freelance writer who covers a variety of personal finance topics for SmartAsset. She is an expert on topics including credit cards and home buying. Danielle has a BA in English from Wesleyan University.