How to Build a Diversified Investment Portfolio
A broadly diversified portfolio helps mitigate risk and manage volatility.
Diversification doesn’t prevent losses, but it can help you reach your long-term financial goals, while making your journey less stomach-churning.
Here’s why diversification is important and how to achieve it.
Diversification is the process of spreading your investments across multiple asset classes, industries, and geographic regions. This strategy minimizes the risk of losses by reducing the impact of any single investment or asset class performing poorly. Diversification also helps to ensure more consistent returns.
The role of asset classes
Asset classes are broad categories of investments with similar risk and return characteristics. The primary asset classes include:
• Stocks (Equities): Represent partial ownership of a company and provide the opportunity for capital appreciation and dividend income.
• Bonds (Fixed Income): Debt instruments issued by governments or corporations, paying periodic interest and returning the principal upon maturity.
• Cash and cash Equivalents: Short-term, highly liquid investments like savings accounts, money market funds, and certificates of deposit.
• Real estate: Ownership of physical property directly or through real estate investment trusts (REITs).
• Commodities: Investments in physical goods like gold, oil, or agricultural products, usually through futures contracts or ETFs.
Each asset class offers different risk and return profiles. A diverse investment portfolio includes a mix of these asset classes to balance risk and return.
Diversifying within asset classes
To build a well-diversified portfolio, it’s important to diversify within each asset class. This can be achieved by:
• Investing in different industries: By spreading your investments across various sectors like technology, healthcare, and finance, you can reduce the impact of industry-specific risks.
• Choosing investments with different risk profiles: Within each asset class, investments can vary in risk. For example, large-cap stocks are less risky than small-cap stocks, and corporate bonds are more risky than government bonds.
• Using index funds or ETFs: These funds offer instant diversification by investing in a broad range of securities that track a specific market index. They are a cost-effective way to access diversified exposure to different markets and asset classes.
Investing in different countries and regions helps mitigate the impact of region-specific economic and political risks. To achieve geographic diversification, consider the following:
• Invest in international stocks and bonds directly or through ETFs and mutual funds.
• Allocate a portion of your portfolio to emerging markets which can higher growth potential but carry higher risks.
• Diversify across developed markets, which tend to be more stable but offer lower growth potential.
Diversification across time
Dollar-cost averaging is a strategy that involves investing a fixed amount of money at regular intervals, regardless of market conditions. This approach can help to reduce the impact of market volatility and improve long-term returns by averaging the purchase price of your investments over time.
Monitor and rebalance your portfolio
Regularly reviewing and adjusting your portfolio is crucial to maintaining diversification.
Consider the following steps:
• Review your portfolio periodically: Check your portfolio's performance and allocation at least once a year to ensure it remains aligned with your investment goals and risk tolerance.
• Rebalance your portfolio: Rebalancing involves adjusting your investments to align with your desired asset allocation. This may require selling some assets and buying others or adjusting the amounts invested in each asset class.
Building a diverse investment portfolio is an important component of prudent investing. You can reduce the risk of significant losses and manage volatility by spreading your investments across multiple asset classes, industries, and geographic regions. To maintain a well-diversified portfolio, it is important to regularly review and rebalance your investments to ensure they remain aligned with your investment goals and risk tolerance.
Here are some helpful resources to help you build and maintain a diversified investment portfolio:
a. Morningstar (www.morningstar.com): Offers comprehensive investment research and analysis, including mutual fund and ETF ratings and portfolio tools.
b. Yahoo Finance (finance.yahoo.com): Provides financial news, market data, and investment tools.
c. Investopedia (www.investopedia.com): Offers educational articles and resources on various investment topics, including diversification and asset allocation.
d. The Bogleheads' Guide to Investing, by Taylor Larimore, Mel Lindauer, and Michael LeBoeuf This book is a practical guide to investing, offering insights on diversification, asset allocation, and other investment strategies.
e. The Intelligent Asset Allocator, by William J. Bernstein: This book covers asset allocation principles and offers guidance on building a diversified investment portfolio.
You can successfully build a globally diversified investment portfolio by leveraging this information and these resources.
At Sensible Portfolios, we recommend globally diversified portfolios to our clients.