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Investing is all about strategy. Money managers, fund managers, financial planners, and seasoned investors know that a successful investment strategy is all about diversification. Strategically spreading your money around to protect you from losing all your assets when the market or the economy takes a hit.
If you’re looking to successfully diversify your strategy, the first thing is to understand what types of investments are available, how much money to put into each one, and how to further diversify within each particular category. There are quite a few alternative investments for you, but here’s a useful guide to help you understand how to wisely construct a diversified investment strategy.
First of All, Why Diversify?
Investing is like coaching a sport. You want to make sure you’re using all your available players to the best of their ability within your strategy. However, you don’t want to rely on just a single star player to win the game.
That’s why in order to win at the investment game, blend different investments in your portfolio to yield a safer, higher return with lower risk, less uncertainty, and more sustainability over the long term. This way you’ll protect your assets and it is easier to do than it sounds.
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4-Step Guide to Easily Diversify Your Investments
Step 1: Have Many Different Investments in Your Portfolio
Investing in ETFs, index funds, and mutual funds will give you instant diversification without getting things too complicated.
ETFs and mutual funds act as a container of different stocks and usually mirror a specific index, like the S&P 500, for example. Make sure you read about each ETF or mutual fund before buying them because fees and what’s inside can differ.
Step 2: Diversify Within Each Type of Investment
When you invest in stocks, for instance, don’t focus all your efforts into a single or just a few stocks. What you want to do is invest in different stocks in different sectors. Make sure you invest in a mix of stocks of companies with different characteristics like growth, size and even where the company is based.
Regarding assets like bonds, consider bonds with different credit qualities, duration, and maturities. Use this type of approach in each part of your portfolio.
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Step 3: Vary Your Risk
When constructing your investment strategy, make sure you choose investments with various rates of return. Different rates of return will ensure some investments with substantial gains offset losses in other investments.
Looking at foreign stocks is a great way to balance out your investment risk. These stocks tend to perform differently than U.S. stocks. You might also want to include small-cap or mid-cap stocks, which are smaller companies with more risk but also faster growth..
Step 4: Diversify and Rebalance Regularly
Diversification is not a one-time thing. Make it a regular task to check your portfolio every so often to make changes according to your needs, the market, and your financial goals or strategy. A good rule of thumb is to do this at least once every few years.
So, What Should Your Portfolio Include?
Domestic stocks to help your portfolio grow
By owning stocks (a piece of a company), you’ll be receiving benefits such as dividend payouts regularly and then price appreciation when you sell. Stocks are the biggest part of most investors’ portfolios because they offer the highest returns over time.
Bonds Bring Income
Bonds are less volatile than stocks and as an income-generating asset they offer regular interest income. This makes them a more “stable” investment to balance out riskier investments and they can provide great cash flow in retirement.
Make sure your portfolio includes short-term certificates of deposits and money market funds. These offer stability and easy access to your investments. Some are insured/guaranteed by the government, making them safer still.
Build a good mix of international investments to protect your portfolio against local market shocks. These investments will help you maintain growth and expose you to different opportunities.
These investments focus on specific sectors/segments of the economy. Including them in your mix opens interesting opportunities for you in different parts of the economic cycle.
Real Estate Funds
There is a low correlation between real estate and stocks, meaning both don’t necessarily rise or fall at the same time. It also means combining them is a great way to balance risk. Plus, real estate funds provide a hedge against inflation.
Asset Allocation Funds
These types of funds are a great way to diversify for those of you who don’t have the expertise or time to build a diversified portfolio by themselves.
Include cash investments in your mix to add more security and stability to your portfolio.
It’s also a good idea to put some of your money into a savings account. These types of accounts get interest. You might want to use this account to save money towards a specific goal. Use this savings account calculator to get an idea of what your saving plan would look like.
Can You Be Too Diversified With Your Investments?
Some of the most common problems with diversification include inadequate diversification or a complete lack thereof. Another extreme though is too much diversification. To avoid over-diversification, you can get the help of financial advisors or managers, or even use one of the investment apps out there. Or, to know if you’re too diversified, you can start by answering the following questions and see how to reach the perfect balance.
1. Are Your Fees Out of Control?
A fine-tuned portfolio will consist of about 20 to 30 individual securities and funds; but if you over-diversify, you may find yourself holding 60, 80, 100 or even more individual securities and funds. This will translate into way too many transaction fees, which translates into reducing the return on your portfolio, and a substantial negative impact on your long-term investment goals.
2. Are You Consistently Underperforming the Market?
The process of diversification aims to minimize risks during bear markets and take full advantage of bull markets. So, if you constantly find your portfolio’s performance to be below the general market, it could be a symptom of too much diversification.
3. Is Your Portfolio-Managing Time Getting out of Control?
If you find yourself spending way too much time monitoring your positions, rebalancing, and generally managing your portfolio, this could be a sign of an over-diversified portfolio.
4. Did Your Portfolio Loose Consistency?
Just like everything else in life, there is such a thing as too much. Too much diversification in your portfolio might result in diminishing returns. If you notice that your diversification strategy is just adding a little bit of this, and a little bit of that, then you might want to stop and recalculate. The idea is to be sufficiently diversified to protect your portfolio, but you don’t want to be so over-diversified that your portfolio is incapable of participating in bull markets in any meaningful way.
Balance and Strategy
Just like any other tool or approach, diversification requires you to be very strategic in how you implement it. Think of the long term results you want to achieve, as well as your more short term goals and try to strike a balance.
Also aim to achieve that balance between risk, stability, return, and protection. That way diversification will prove to be a smart approach when building and growing your investment portfolio.
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