Whether you’re investing in stocks or real estate, you’re probably going to hear a lot about the importance of diversifying your portfolio. Portfolio diversity is a critical way to protect your investments from market risks and improve the likelihood that your total investment earnings will grow.
This guide will teach you how to diversify your portfolio, no matter which kind of asset you’re investing in.
What Is Portfolio Diversification?
Diversification is a practice in which you invest in different types of assets or securities.
Diversifying your portfolio has two main advantages:
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Your investments are better protected
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There’s a greater likelihood that your portfolio will grow in value
You reduce your overall risk by spreading your investments across a broad spectrum of assets and industries. Not only does this safeguard your portfolio from sudden drops, it also increases your ability to benefit from a variety of sources.
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What Should Go Into A Diversified Portfolio?
A diversified portfolio is made up of several different investment types, including stocks, bonds, real estate, and REITs. The key is to spread holdings across various groups to ensure that your portfolio’s performance isn’t dependent on one asset type.
Many investors follow the 60/40 rule, where 60 percent of an investment portfolio is made up of stocks, and 40 percent is fixed-income investments. However, this is not a hard and fast requirement for a diversified portfolio. Ultimately, the right asset makeup depends on the investor’s investing personality and goals.
Before You Start Diversifying Your Portfolio
Before you begin the task of diversifying your portfolio, there are a couple of things to consider.
The first is to be aware of your own biases. You might have financial prejudices and ideas that can influence your decision-making. Our family attitude toward money and risk, luck, and cultural beliefs are all examples of conditioning that can contribute toward our biases.
While none of these elements are inherently good or bad, it’s important to pause and reflect if your decision-making might be influenced by your bias. For instance, let’s say you come from a wealthy family and you watched your father have success with high-risk, high-reward investments. When building your own portfolio, you’re tempted to only invest in high-risk stocks. With the goal of diversification and hedging risk in mind, this is where the bias begins to creep in. By checking your bias, you’re reminded that you want to add in some low-risk investments to counterbalance your high-risk investments.
The second thing to be wary of is the risk of over-diversifying your portfolio. Over-diversification often happens when you already have an ideal mix of securities in your portfolio and you want to keep adding more securities that are closely-correlated. If a new investment increases your risk and lowers your expected return, then it doesn’t serve your goal of diversification.
How To Diversify Your Portfolio In 10 Steps
Many Americans have been victims of numerous economic downturns, including the dotcom crash, the Great Recession, and the COVID-19 recession.
These economic events serve as a great reminder of why it’s so important to spread your risk across multiple asset types. Investors who put “all their eggs in one basket” often suffer during hard times. Smart, regular, and disciplined investing decisions over time are what provide results in the long run, even when encountering downturns in the market.
Here’s how to diversify your portfolio in 10 steps:
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Learn Why You Should Diversify Your Portfolio
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Allocate Your Assets
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Learn The Risks Of Each Stock Before Investing
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Invest In Money Market Securities
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Invest In Systematic Cash Flow Bonds
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Study Financial & Global Markets Regularly
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Balance Your Investments Regularly
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Try A Systematic Investment Plan (SIP)
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Invest In Life Insurance
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Invest A Portion In Real Estate
1. Learn Why You Should Diversify Your Portfolio
Before you begin to diversify your portfolio, you should learn why it’s both critical and advantageous. Understanding your “why” will help you better navigate the process and make decisions that will help you achieve your goals.
The purpose of a diversified portfolio is to help your investments better absorb any shocks from economic disruption. You can diversify by increasing the types of assets you invest in, as well as classes of each security. You can also diversify across different industries.
That way, you’re not “putting all of your eggs in one basket.” The COVID-19 pandemic serves as a perfect example for why diversifying is always a good idea. Certain industries and sectors soared, while others absolutely tanked. Because no one holds a crystal ball, it’s best to diversify your portfolio and improve your chances overall.
2. Allocate Your Assets
Allocating your assets is tricky because it’s a balancing act between risk and surety. For instance, stocks can offer high returns but come with higher risk. In the meantime, bonds provide lower returns but are steady.
Figuring out your ideal allocation ratio depends on your age and financial goals. Let’s say you’re a younger investor who wants to earn high returns and can afford to take on more risk. You might allocate 70 percent of your investments to stocks and 30 percent to bonds.
Alternatively, let’s say you’re in your fifties and would like to retire relatively soon. You are risk-averse and your primary goal is to earn a reliable retirement income. Here, you might flip the ratio and allocate the majority of your investments to bonds.
3. Learn The Risks Of Each Stock Before Investing
Before buying or selling any type of investment, analyze the risks. Risk analysis uses many different parameters, such as performance history, corporate governance, regulatory compliance, and brand value.
What you’re doing here is taking a broad look at the company and taking an educated guess of whether their stocks will increase or decrease in value.
Luckily, many investing apps, platforms, and publications conduct research on your behalf. Although you should always do your due diligence, many investors rely on the rich analysis provided by highly skilled investment analysis.
4. Invest In Money Market Securities
Be sure to add money market securities to your portfolio. Examples include certificates of deposit (CDs), commercial papers (CPs), and treasury bills. These securities are low risk, and they’re one of the easiest investments to liquidate in a pinch.
5. Invest In Systematic Cash Flow Bonds
If you’re someone who wants to access cash even while your investments are tied into a savings plan, consider mutual funds with systematic cash flow. These are also called systematic withdrawal plans (SWPs.)
These investments allow you to make monthly or quarterly withdrawals. You get to customize how much you’d like to withdraw, such as fixed amounts or against your profits.
A systematic transfer plan (STP) is a great alternative that allows you to transfer fixed amounts between different mutual funds. This is a great way to fine-tune and balance your portfolio.
6. Study Financial & Global Markets Regularly
Regularly study financial and global markets to understand what makes the money market move. Most of economics boils down to the simple concept of supply and demand, but there are many factors that influence its movement. Some external influences include inflation, interest rates, and Federal Reserve policies.
As you gain more experience, you’ll also learn how to analyze global markets and take advantage of different currencies.
7. Balance Your Investments Regularly
Your investment portfolio is not a “set it and forget it” plan. The money market moves 24/7, which means that your investments require regular balancing and fine-tuning.
Your personal financial advisor or robo-advisor can help you review your portfolio performance against your financial goals. If adjustments need to be made, they will advise you on alternative options.
8. Try A Systematic Investment Plan (SIP)
If you don’t have a lump sum of cash to invest at once, you can still invest in small amounts over time. In this case, a systematic investment plan (SIP) might be a good option for you.
This allows you to invest small amounts of money in mutual funds every month. Don’t forget, small and steady wins the race.
The investment amount is withdrawn directly from your bank account and is a great way for beginner investors to get started. This will teach them discipline and expose them to the concept of setting aside a set amount each month towards the future.
9. Invest In Life Insurance
A life insurance policy may not strike you as an investment, but it is. If you’re a young investor, you may not have considered buying a life insurance policy before. However, this is actually the best time to get in. Young, healthy people can nab the lowest policy rates.
10. Invest A Portion In Real Estate
Consider real estate as a way to diversify your portfolio. Real estate investments are known to help increase a portfolio’s overall returns while reducing risk.
If you don’t have the means or bandwidth to invest in real property yourself, there’s good news. You can invest in real estate by investing in Real Estate Investment Trusts (REITs.) These are investment groups that pool investor funds together to buy income-producing commercial real estate. This means that as an investor, you get to enjoy the partial profits of commercial properties that you otherwise wouldn’t have access to. To learn more about investing in REITs, be sure to check out our REIT investing for beginners guide.
Expert Tips For Diversifying Your Portfolio
Now that we’ve walked through the steps of how to diversify your portfolio, keep these expert tips in mind:
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Don’t Over-Diversify: Diversification is not a bulletproof investment strategy, and it won’t provide 100% protection for your assets. Also, remember that you may suffer from low returns if you’re not well-invested in any of your assets. You could miss out on growth. For example, it might be more lucrative for you to invest $500 each in 10 companies than to invest $50 each in 100 companies.
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Choose Your Broker Carefully: If you know you’re going to be investing in stocks or ETFs, be sure you select a broker that offers low trading costs or no trading costs. Online brokers usually offer commission-free trading for stocks and ETFs.
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Pay Attention To Commissions: As you identify new investments, be sure to pay attention to the fees and commissions associated with trading and selling. If you work with a portfolio manager, always be aware of their fee structure as well.
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Keep Building: When you reap the returns of your diversified portfolio, consider how to best reinvest. Many investors rely on dollar-cost averaging, a strategy that sets aside a certain portion of returns for future investments. No matter which method you choose, take advantage of your portfolio growth and keep looking for opportunities to diversify and invest.
How to Diversify Your Real Estate Portfolio
Real estate is one of the most lucrative asset classes, and it’s a great way for any investor to diversify their portfolio—even those who prioritize securities.
You can diversify your real estate portfolio in the same way you diversify your securities: you’ll invest in different asset classes. In other words, you’ll invest in different types of properties.
Residential rental properties, Vacation rentals, and fix-and-flip investments are real estate investments you can do for diversification. But you can create further diversification by investing in multifamily properties, commercial properties, and REITs.
Investing in Multifamily Properties
A multifamily property, also known as multi-dwelling units (MDU), is residential housing with two or more units under a single roof. This is the least common type of residential building, and it’s compelling for investors because it can produce a larger cash flow than a single-family rental property. That means it carries less risk.
The benefits of investing in multifamily properties include:
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Less Risk: For rental properties, the biggest risk is the loss of income, which typically happens through a vacancy. Since an MDU has more units, it can alleviate the total economic loss for vacancies that occur.
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Cash Flow: An MDU can generate a cash flow that’s much higher than a single-family rental property, so long as the MDU can produce rent prices that create sufficient profit to cover the mortgage costs.
Investing in Commercial Properties
Commercial properties, like office buildings and shopping centers, are a natural progression for experienced real estate investors.
“Making the jump from single-family homes to learning how to invest in commercial real estate can be an incredibly lucrative career choice,” says Than Merrill, my colleague at FortuneBuilders and CT Homes. “However, commercial real estate investing is a different animal; the numbers on a single deal alone can trump even the most expensive single-family homes. Investing in commercial real estate will require a new set of skills, and some people will want to make the transition a little slower.”
The benefits of commercial properties include:
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Less Competition: Commercial properties are a major undertaking for investors because they’re expensive and require complicated financial planning. But they’re also lucrative for the few investors who can handle the workload.
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Cash Flow: Because commercial real estate leases are generally longer than residential rentals, investors have a unique advantage over traditional investors to earn relatively consistent and reliable income every month. Commercial real estate will typically earn a better return on investment than single-family homes, fetching between six and 12 percent, compared to residential properties that will earn between one and four percent.
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Triple Net Lease: The general concept involves having tenants pay for the building’s taxes, property insurance, and maintenance costs, in addition to the monthly rent. Although there are many variations, the idea aims to have property owners pay no expenses on the property other than the mortgage.
It’s important to know that the commercial property market could be in flux. It’s possible that the COVID-19 pandemic could permanently increase the number of Americans working from home while reducing the demand for commercial properties. There could be some exciting opportunities for investors who are paying close attention to the market.
Investing in REITs
A real estate investment trust (REIT) is a company that owns or finances income that produces real estate.
They work similarly to stock investments by offering common shares to the public but are contingent on the state of the real estate market rather than on an exchange. In essence, REITs are part of a private and public equity stock in real estate companies that invest in properties, mortgages, and other real estate-related investments. They offer all types of regular income streams, diversification, and long-term capital appreciation.
“In addition to the passive income rental properties and rehabs that have become synonymous with today’s residential redevelopers, investors must solidify long-term yields with the help of an REIT portfolio,” says Merrill. “Nothing, at least that I am aware of, carries more promise for long-term dividend yields at the moment than real estate trusts.”
Unlike direct real estate investments, where local property markets influence values, REITs are continuously valued, which can be both good and bad for investors. That said, investing in REITs is a terrific option for investors looking to diversify their real estate investment portfolio.
Summary
Diversification is a practice in which you invest in different kinds of assets. It can help you protect your investment portfolio from underperforming assets, and it can boost your chances of investment growth. There are many different methods on how to diversify your portfolio: allocating your assets, prioritizing “basket-style” investments, and investing in a variety of different asset classes. To diversify a real estate portfolio, invest in different properties, especially in commercial properties, multi-dwelling units, and REITs.
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