Managing portfolio risk is one of the most important considerations for investors.
Diversification is a risk management strategy that mixes a wide range of investments types within a portfolio. This practice is designed to protect against market volatility. The reason behind this technique is that portfolios constructed of different kinds of assets can yield higher long-term returns while lowering the risk of any individual investment.
There are a number of ways to go about diversifying your portfolio. Continue reading to learn more about portfolio diversification, components of a diversified portfolio and strategies for achieving true diversification with Eric Scott Financial Strategies.
What is Diversification?
Diversification is a long-term investment strategy that aims to increase returns and decrease overall risk by allocating capital across different investment types and industries. The key to building a diversified portfolio is looking for investments whose returns haven’t historically moved in the same direction or at the same degree. So even if a section of your portfolio is declining, the rest of your investments could still be gaining.
Primary Components of a Diversified Portfolio
Your diversified portfolio should include the following mix:
Stocks are the most aggressive portion of your portfolio and provide the opportunity for higher growth over the long term. However, this greater growth potential also carries a greater risk, particularly in the short term. Stocks are generally more volatile than other asset types and if you decide to sell, it could be worth less than when you purchased it.
Bonds generally provide regular interest income and are generally considered to be less volatile than stocks. They can act as a cushion against the ups and downs of the stock market. Investors focused on safety, rather than growth, often favor high-quality bonds. While you may have to accept lower long-term returns, you do not have to deal with the high risk of short-term loss. However, some fixed income investments, such as high-yield bonds or international bonds, can offer higher yields, but also come with greater risk.
Short-term investments include money market funds and short-term certificates of deposit (CDs). Money market funds are a more conservative investment that offer stability and easy access to your money. These generally offer lower returns because they provide a high level of safety. While they are low risk, they are not insured or guaranteed by the Federal Deposit Insurance Corporation, as CDs are. However, when you invest in CDs, you may sacrifice the liquidity that’s usually offered by money market funds.
Stocks issued by non-US companies provide opportunities not offered by US securities. While these can be higher risk, they also have the potential for greater returns. Foreign stocks often perform differently than their US counterparts and aren’t susceptible to the volatility of the US stock market.
Strategies to Diversify Your Portfolio
- Diversify across asset classes
Diversification of your portfolio through this technique involves investing in several types of asset classes. This can include traditional assets such as stocks, bonds and cash, that operate in the public market. You could also consider going a step further and adding alternative investments into your portfolio as well. This includes hedge funds, private equity, real estate commodities and collectibles. Alternative investments primarily operate in the private market and are largely unregulated. These can be beneficial because they tend to have low correlation with traditional assets and the volatility of the stock market.
- Diversify within an asset class
One of the most common strategies for portfolio diversification is investing in various assets within the same asset class. There are a few different ways to go about this. For instance, you can invest in only stocks, but diversify the industry in which the companies reside in. If you invest in bonds you might look for bonds from different issuers and with different maturities. This could also be as simple as buying the market index to ensure a variety of high and low risk stocks across different industries that are equally represented in your portfolio.
- Diversify by location
As mentioned above, another strategy is to start looking abroad. If your country’s market starts to take a downturn, this could save your portfolio by having some international investments. Keep in mind, though, that other countries may have different rules, regulations and processes for investing than your country does.
Creating an Investment Plan That’s Right for You
Diversification is not a one time task. It takes management, and your strategy should be adjusted if your financial situation changes. Additionally, there are a number of factors that should go into your investment decisions, like time horizon and risk tolerance.
The closer you are to retirement, the less risk you want to be taking when it comes to your investment portfolio. This is because you won’t have the time to make up for losses in the event of a down market. You might even consider reallocating your assets to reduce exposure to high-risk, more volatile investments. As they near retirement, many investors start their investments in more conservative assets, such as bonds and money market funds.
Looking to begin building a strong portfolio? Or maybe you want to build upon your current investment portfolio?
At Eric Scott Financial, our Financial Architects are here for you. Whether you’re currently in retirement, or just getting started investing, Eric Scott Financial has a tailored plan just for you. Schedule a call with us by calling our office at (435)773-9444 to get started so your retirement can be as fulfilling as you want it to be.