Diversification Strategies for a Robust Investment Portfolio

One of the challenges that you’ll face when building your investment portfolio is risk. And with that comes the need to find ways of mitigating it. One way is by diversifying your holdings, which is the gist of this article. In it, we will explain the concept of portfolio diversification. By its end, you’ll have learned its common strategies and how to apply them in your investment journey.

What’s Portfolio Diversification?

Portfolio diversification is a compound word made up of two terms: portfolio and diversification. Whereas the former refers to a collection of assets that an investor owns, the latter is their differentiation. As such, portfolio diversification is a deliberate act of spreading your investments across several alternatives.

Just like the age-old eggs-in-a-basket adage, portfolio diversification advises against concentrating your assets in one area. That’s because every investment has its risks. So, understanding this concept and its use can help you manage those uncertainties better.

Four Strategies of Portfolio Diversification

Here’s a quick overview of some of the common methods of diversifying your investments:

Diversification By Asset Classes

This is one of the popular ways of diversifying your portfolio. It involves investing in different asset types such as stocks, bonds, funds, real estate, or even commodities. Each reacts differently to prevailing economic and market conditions, so their risks vary, too. Owning a bit of each helps to even the overall risk. 

You can also choose to diversify your holdings within the same asset class. For instance, in stocks, you can have a portfolio that blends growth or value stocks. Additionally, you may opt for stocks based on their market capitalization, i.e., small-cap, mid-cap, or large-cap stocks.

Sectoral Diversification

You can also broaden your investment scope by sector. This method is more suitable for investors in the securities space. Equities traverse different economic sectors, including technology, healthcare, finance, agriculture, hospitality, etc. As these are distinct categories, they respond differently to market changes. 

By holding a basket of pickings from different categories, you cushion yourself from the knocks experienced in one area. For example, you could pair technology stocks with those from the healthcare sector. The former are mainly growth-oriented and will shore up your earnings in bullish conditions. On the other hand, the latter are more defensive, so they would shelter you from market slumps.

Geographical Diversification

Another way of diversifying your portfolio is by investing abroad. Bar issues impacting the global economy, such as the COVID-19 pandemic, countries and regions experience unique economic conditions at any given time. While one may be in the throes of a deep recession, another may be entering a phase of accelerated growth.

Time Diversification

Besides the three strategies we’ve outlined above, you can also use time to diversify your investments. Here, you’ll use the length of time you hold an asset to distribute your funds across your holdings. This form of portfolio differentiation happens in one of three ways.

The first is short-term diversification, which allows you to split your funds between day and swing trading. Moreover, you have medium-term diversification that comprises position trading and seasonal trading. And finally, you’ve long-term diversification that encompasses the buy-and-hold strategy and dollar-cost averaging.

Implementing Diversification in Your Investments

By now, you have a good grasp of portfolio diversification and how you can go about it. The next step is putting it all together. So, let’s see how you can implement it.

Steps of Creating a Diversified Portfolio

Here are a few pointers to get you started on your diversified portfolio:

• Know your investment goals: The first step in diversification is defining your “Why?” in investing. That’s because knowing what you want from your holdings dictates every other decision about them. Ask yourself if you’re in for big gains or whether you seek to preserve your capital.

• Determine your risk profile: Be clear on how much risk you’re willing to take. Look at your time horizon and decide whether you’re an aggressive, conservative, or moderate investor. Aggressive investors have longer timeframes and higher risk tolerances than the other two. So, they tend to allocate bigger portions of their funds to growth assets as the rest seek defensive ones more. 

• Research on the available options: Explore every asset that you wish to include in your portfolio. Understand how each works and their inherent risks. Additionally, dig into their historical performances. This scrutiny will help you decide on the options that best align with your investment objectives.

• Establish Correlations: Portfolio diversification is about funding the right blend of investments. To do so, you’ll use the concept of asset correlation, a measure of the dependency between holdings. There are three types of asset correlations: positive, zero, and negative, and the last two are crucial to a properly diversified portfolio. Pick assets with very low or negative correlations, as shifts in one tend to have little, if any, shifts in the other. This helps balance overall portfolio risk.

• Decide on the allocations: At this point, you must decide how big you want your portfolio to be. That is, how many assets to include. Secondly, determine the amount you’d like to put into each holding. Look at your budget, investment goals, time horizon, and risk profile while making these decisions.

• Monitor and rebalance regularly: Track your portfolio’s performance and adjust your allocations to cover market fluctuations. Rebalancing optimizes your holdings, enhancing the odds of meeting your investment goals. Also, keep abreast of the major economic and geopolitical events that may impact your holdings.

Tools and Resources for Portfolio Diversification

Setting up a properly diversified portfolio may be taxing. But it doesn’t have to be so. With a little initiative, you can find tools and resources to help you along. 

One of the easiest resources is human advisors. These professionals in the investment space will work with you to develop a plan that fits your needs. You may find them at your local brokerage firm or even online. Be aware that they may charge fees for their services.

Alternatively, you could opt for robo-advisors. These are investment apps and software that use algorithms to build you a suitable investment basket. Their major downside is that they are robots, so interacting with them lacks the human touch.

You can also use various asset allocation tools available online. These study your strategies and suggest ways of optimizing your portfolio. Prominent examples include Morningstar Portfolio Manager and Personal Capital.

Again, there’s extensive literature on the subject on the web. Besides, you can join investment communities where members share thoughts and experiences on how to manage your holdings best. 

The Pros and Cons of Portfolio Diversification

We shall shortly see the benefits of diversifying your investments. But the practice has its drawbacks. So, in this section, we shall look at both sides of this coin, starting with its positives.

Pros

• Lessened risks: Diversification softens the effects of a single asset’s poor performance on the entire portfolio.

• Consistent returns: The contrasting performances of the assets balance out the losses throughout the portfolio. This aspect allows you to enjoy regular returns throughout your portfolio’s lifetime.

• Enhanced Risk-Adjusted Returns: Spreading your investments enables you to earn more income per unit of risk. 

• Expanded Access to Investment Opportunities: Diversification lets you take advantage of a range of investment opportunities, thereby enhancing your earning ability. Besides investing in different asset classes, you can access various sectors and even geographical markets.

• Capital preservation: By diversifying your portfolio, you’re guarding against market volatility. Over the long-term this will help you accumulate wealth for your sunset years.

Cons

• Reduced returns: Diversification is a cautionary approach to investing. This defensive focus could deny you higher gains from assets that perform well.

• It takes work: Crafting a properly diversified portfolio takes time and effort. That can be a challenge if you have a busy schedule.

• Possibility of incurring fees: You’ll incur fees for using human and robo advisors to set up your nest egg. These fees eat your potential returns.

• Tax implications: Every asset you include in the portfolio attracts tax. Consequently, you may pay more to the taxman than if you had concentrated your investments.

Conclusion

In conclusion, while risk is inherent in all investments, it’s crucial for every investor to mitigate its impact. Throughout this article, we’ve explored one effective strategy: portfolio diversification. While it’s not foolproof, adopting this approach can provide a sense of security that would otherwise be absent if all your investments were concentrated in one area.