Diversification1 is not just a financial tip to help you build out your investment portfolio. It is also a crucial strategy to reduce volatility. If your investments aren’t spread across the right combination of holdings, a single event could trigger catastrophic loss.
Unfortunately, most investors don’t understand what it takes to craft a diversified investment portfolio, costing them piles of cash in the long run. However, there is a smart approach to diversification. In this article, we dive into the benefits of diversification in your investments and lay out some simple tips to help power your diversification strategy.
What Is the Definition of Diversification?
Most simply, portfolio diversification describes how well you spread your investments across different assets and holdings. By peppering your investments into different areas, you divvy out risk and protect your broader financial portfolio.
Still, many investors believe their investments are diversified but are jolted by a frightening awakening when markets slide or an event pulls down an asset class. To protect your investments, you need to do more than just drop your money into a few different stocks or exchange-traded funds (ETFs). Instead, you need to take a multi-dimensional approach when investigating your portfolio’s diversification level—one that drills into where your money is sitting and where risks are looming.
The Benefits of Diversification in Your Investments
Diversification can fortify your investment portfolio and position your money to climb higher with fewer downturns. Here are a few of the benefits of diversification in your investments:
- Protect against market crashes: When a financial market dives, you don’t want all of your investments to be wiped out. By spreading your investments across sectors and asset classes, you avoid putting all of your eggs in one basket. That means you protect your investments when the market takes a nosedive.
- Avoid sector-by-sector pitfalls: Often, an entire sector will face headwinds, pulling similar companies’ stock prices down simultaneously. By diversifying your portfolio to include many sectors, you face less financial risk when these sector-wide pitfalls hit an industry.
- Position yourself for more opportunities for return: When you diversify your portfolio, you can minimize the risk of one bad event tanking your investments. You also minimize the risk of missing out on growth opportunities. By having a well-diversified portfolio, you are more likely to have investments in areas that are performing well.
Tips to Inform Your Investment Diversification Strategy
You don’t have to be a financial expert to strengthen your investment diversification strategy. Here are a few tips to diversify your portfolio:
1. Understand the dangers of high market correlation.
It’s easy to assume a common ETF will automatically diversify your portfolio. However, popular funds often look diversified, but actually include holdings that share risk. For instance, the S&P 500 Index seems diversified because it consists of 500 different companies. But what many investors don’t realize is that it is heavily market-weighted so investments are concentrated to the few largest companies. If an event undercuts big techor there is a market correction, your entire portfolio could be yanked down.
At the same time, you can’t assume investing in a handful of ETFs will diversify your portfolio. Different ETFs may hold a hefty chunk of the same sectors or even the same companies and be built on shared risk. For instance, if two ETFs are composed of a high percentage of the same tech companies, they could lose value if there is a chip shortage or other sector-wide challenge.
Wondering how to fight off the dangers of high market correlation? The easiest way is to look under the hood of every fund and ensure they aren’t holding too many of the same stocks. Another way to cut down risk is to invest in ETFs that are weighted to include diversity. That way, you can see how diversified the ETF is upfront.
2. Dig into shared risk.
Another way to diversify your portfolio is to examine shared risk. You will need to identify the risks that specific holdings face and look for overlap within your portfolio.
Remember, different sectors could share the same risk factors even if they don’t offer the same services. For instance, if you decided to split your investments across air travel and apparel sectors, it may feel as though your portfolio is diversified. However, the two sectors could be exposed to similar inflation risks because each industry relies on material costs, such as fuel for airlines and commodities for apparel companies.
To protect your investments, try to identify which entities face the same potential market disruptions, examine what percentage of your holdings share risk, and try to pick ETFs that include investments that won’t lose value at the same time.
3. Spread investments across asset classes.
Diversification doesn’t just mean picking ETFs that are diversified. To squeeze the biggest benefits out of diversification, you need to diversify the types of assets you pick up. For instance, you may want to split up investments between equities and bonds. This strategy can protect your portfolio against market-wide swings because bonds and equities often react to sharp market moves differently.
As a general rule of thumb, you may want to shoot for a 60/40, equities-to-bonds investing strategy. That means 60 percent of your portfolio will include equities, and 40 percent of your money will go into bonds. This is a simple way to balance asset allocation, shrug off market-wide setbacks, and keep returns steady when most investors start panicking.
Learn More Ways to Increase Your Investing Power
An important aspect of investing is to equip yourself with knowledge. The more you know about managing your investments, the more likely you will see success in your portfolio.
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