Creating a Diversified Portfolio
Even the savviest of investors need to think about portfolio diversity from time to time. What, exactly, does that mean? We’re looking at all-things-diversification here. We’ll cover how to create a stock portfolio that’s balanced and diversified, so you can have the best opportunity to grow your investments over time, while mitigating some of the risk.
What is Portfolio Diversity?
Portfolio diversity is a risk management technique. The goal is not to maximize investment returns, but rather to balance risk by building a diversified portfolio. The idea behind portfolio diversification is that if a portion of a diverse stock portfolio is not doing well, the other balanced allocations can compensate for the losses. That old adage about not putting all your eggs in one basket can really sum up the concept of building a diversified portfolio.
To truly understand the idea of diverse portfolio allocation, you must first grasp how diversity reduces risk.
Positive correction: Think about the value of one investment going up - the value of another investment also goes up simultaneously and for a similar amount.
Negative correlation (or reverse correlation): The opposite - when the value of one investment goes up and the value of the other investment with a negative correlation goes down.
Understanding this correlation effect helps investors learn how to diversify.
Why Diversification Matters
Creating a diversified portfolio can be one way to reduce risk and stay on track so you can achieve long-term financial goals. If you have all your investments concentrated in just a few assets, and the value of any specific asset class goes down, you may suffer a major loss.
On the other hand, if you have a balanced portfolio that’s weighted properly, you’re invested in many assets. You won’t necessarily lose everything if one asset class goes down. This method is how to build a diversified stock portfolio.
Diversified Portfolio Examples
A couple of diversified portfolio examples are a stock index, and a mutual fund.
The Dow Jones Industrial Average (DOW 30) is the combined performance of 30 different companies. The list has large publicly traded U.S. companies and changes constantly depending on a company’s performance.
To invest in the DJIA, you can buy shares of individual companies or buy an exchange-traded fund (ETF) that focuses on replicating the DOW 30 list for you. Over the past ten years, the DJIA annual return has been as low as a loss of -5.63% in 2018, to a high in 2013 of 26.3%. The past ten-years average return was 15.03% (June 30, 2019).
Some companies in the DJIA went up, and some went down. However, together the diversified portfolio of those 30 companies did well. The winners made up for the losers.
A mutual fund is another example of how you can diversify your portfolio. Investors can choose a mutual fund based on its allocations, investment goals, risk and fees.
Tips For Building a Diversified Portfolio
Many investors like to build their diversified portfolios by choosing the stocks themselves. Here are the steps on how to build a diversified portfolio.
How to Create a Stock Portfolio
ETFs & Mutual Funds
Exchange-traded funds and mutual funds provide many choices that make it easy to diversify a portfolio. If you think an industry sector, a region or a certain type of company will do well, you can add a mutual fund or an EFT that invests in them as a diversified stock portfolio example.
Varying Rates of Return & Risk
In general, the higher the potential return, the greater the risk. If you invest in junk bonds that pay 18% annual interest, you may find that the company goes bankrupt. Don’t let the illusion of a huge return sway your decision. Instead, look for varying rates of return that are different categories. It’s a reasonable strategy to invest a small portion (say, 5% to 10%) of your portfolio in risky investments, but you certainly don’t want to only invest in high-risk opportunities.
Alternative investments that aren’t stocks, bonds or cash can be a good way to help diversify your portfolio.
Consider these alternative investments when learning how to create a diversified portfolio:
- Real Estate Investment Trusts (REITs)
- Crowd-Funded Real Estate
- Precious metals (coin stacking)
- Collectibles such as fine wine, artwork and vintage automobiles
Looking for more suggestions? Check out our Alternative Investment blog post.
Each year (or more often), you want to check your portfolio for rebalancing. Look for too much of one type of investment compared to others in your portfolio. Diversification is not something you can just set and forget.
If this diversification effort sounds like too much work, you can always invest a certain amount on a regular basis in the DJIA, S&P 500 or another index fund. This method is a dollar-cost averaging strategy, which typically performs better than any choices made by an average investor. Build up your tax-deferred retirement funds and let the value accumulate over as many years as possible.
Portfolio diversification provides new opportunities for investors. Look for places in the market that you can utilize this strategy, and you could find the incredible returns you’ve been looking for, while not risking everything.
Sign up with Connect Invest to learn about even more diversification opportunities, such as Short Notes that are diversified among multiple real estate projects and loans to reduce the risk for investors. Investing in alternative real estate investment opportunities like those that Connect Invest offers can further diversify your portfolio and let you continue to build wealth.