If you have been active in the world of stocks and bonds, you must have come across the phrase diversified investment portfolio. In simple terms, it’s another way of saying not putting your eggs in one basket, and we know the reasons for that kind of action. Whereas such a description helps us understand the essence of diversification, it does not give the real meaning of the term as it is used in the investing world nor the practical implications.
This article will give you a more articulate description of diversification from an investor’s perspective. It will also help you understand the practical aspects of diversification and how to build a diversified investment portfolio.
What is diversification?
According to the Goldman Sachs Asset Management Glossary, diversification is a risk management technique that involves spreading an investment portfolio among multiple asset classes with varied levels of risk, industry, and geographic exposure. J P Morgan has a slightly different view. It says diversification is a process of owning diverse investments that perform well at different times to mitigate the effects of volatility in a portfolio and increase the potential for increasing returns.
The Goldman Sachs view gives more weight to the initial understanding; diversification is a risk management technique, and rightly so. However, the view provided by JP Morgan introduces some aspects not mentioned earlier: that it is a process and could also be a way to enhance portfolio performance. We can infer that diversification is a process. It entails spreading an investment portfolio across various asset classes, geographies and industries to hedge against volatility and enhance portfolio performance.
What should a diversified investment portfolio look like?
As the name implies, a diversified investment portfolio should contain various assets in different predetermined proportions. The ratio of the mix, for example, a 70/30 portfolio strategy, depends on the investor’s financial goals and risk tolerance. Here are various approaches investors diversify their portfolios:
An across-asset diversified portfolio includes a mix of stocks for growth, bonds for stability and other assets like real estate, commodities and precious metals to guard against inflation. The primary goal is to mitigate the effects of volatility. If there is a downturn in one asset class, like stocks, investments in the more stable asset classes like bonds or real estate would cushion the portfolio performance.
Within an asset class diversified portfolio develops by spreading investments across different industries, but within the same asset class. For instance, your investment portfolio could consist of stocks. However, the equities could be from different industries like financial, tech, manufacturing and so on. Such an approach cushions an investor where there is an industry-specific downturn.
A geographically diversified investment portfolio entails holding a mix of local and international assets. The main objective is to reduce reliance on the performance of a single economy. Such diversification is essential because the economic performance of a single economy could be extreme or outright bland.
A risk profile diversified investment portfolio consists of low-risk and high-risk assets. The main goal of this approach is to make a portfolio resilient. For instance, one could put their money in blue-chip stocks and treasury bonds (low-risk assets) and also invest in high-risk assets like private equity, precious metals and high-yield bonds.
One can also diversify their investment portfolio by mixing the maturity dates of fixed-income assets, tangible and intangible assets, and investing in traditional and non-traditional assets. Either way, the point is to mitigate the effects of volatility and enhance portfolio performance.
How to build a diversified portfolio?
We mentioned in the opener that building a diversified portfolio is a process, not a one-time event. Therefore, one must actively engage in managing their portfolio to achieve the right mix. The process is continuous because it involves periodic rebalancing of the portfolio. Below are steps that will help you establish a diversified investment portfolio.
Invest in mutual funds
This may seem like investing in a single asset class. However, it is intrinsically the simplest way for investors to diversify their portfolios and avoid the nitty-gritty of managing the investment.
Mutual funds allow investors to pool their investments under one umbrella and let the experts do the work on their behalf. The fund managers assure investors of some return and collect fees and commissions in return. If you would prefer managing your assets personally, use the steps below to build a diversified investment portfolio.
Set clear financial goals
Smart investing begins by understanding your financial goals. Define what results you would like to see at the end. Is it long-term growth and wealth building? Is it a short-term income? Or is it a combination of both?
If your objective is to maximise short-term income, your portfolio could be aggressive (maximising growth and returns) with a higher percentage of high-return assets. For example, 60% on stocks, 30% on alternative asset classes and 10% on bonds and other less volatile asset classes.
If your objective is to safeguard your wealth, the investment portfolio could be more conservative (focused on stability and assured returns). The mix could consist of 60% fixed-income assets like treasury bonds, 20% blue-chip stocks, 10% in cash and 10% alternative asset classes like real estate.
A combination of the two would result in a more balanced investment portfolio.
Diversify according to your risk tolerance
Your risk tolerance and time frame play an essential part when building a diversified investment portfolio. If you are a younger investor, the assumption is you have more room for investing in volatile assets. Therefore, high-volatility assets like equities could form a larger portion of your portfolio.
Some advisors suggest a method where one subtracts their age from 100 to get the proportion to invest in different asset classes. For example, if you are 40, your portfolio mix should consist of 40% stable investments and 60% (100 – 40) volatile assets. However, this formula has not been proven scientifically.
Rebalance regularly
Active management of a portfolio means continuously checking performance and shifting investments to reflect new risk levels and value. For example, a conservative investor will shed some of their stocks and invest in bonds at the end of a bullish year.
Rebalancing will help the investor stay on course to achieve their financial goals.
Finally, avoid chasing performance and ignore the noise.
The investment world is a buzz of activities and opinions. As an active investor, you will come across different opinions on how to manage your portfolio, the best assets to invest in and which ones to let go. Remember, since your goals differ, diversification models will also differ.
Listen to the opinions and advice. After all, most of it is free. However, when building your diversified investment portfolio, stick to your guns. Follow a proven model that will deliver your financial goals. For decades, Warren Buffet’s investment philosophy has been, never count on making a good sale. Instead, buy so low that even a mediocre sale gives good results. He stuck to this and the results are undisputable.
