One of the most critical factors in building a strong, long-term investment portfolio is diversification. In this blog, we’re going to go over what portfolio diversification means, why it’s important, and a few high-level strategies to keep in mind to help minimize risk while maximizing potential in your own investment portfolio.
What is portfolio diversification and why is it important?
Investing in anything carries some degree of risk – some, of course, higher than others. Portfolio diversification is an investment strategy that aims to minimize overall risk by spreading investment dollars across different asset categories. Over the long-term, proper diversification can help make returns more stable.
Portfolio diversification is very much a “don’t put all your eggs in one basket” strategy. For example, if an investor were to strictly invest in the stock market, should the market crash, they risk losing their entire portfolio. This can be applied to every financial market, be it real estate, commodities, international stock, you name it. Under normal conditions, it is unlikely – but not impossible – that all financial markets would crash simultaneously and to the same degree.
In addition to investing across different financial markets, portfolio diversification also means investing across different opportunities within the same asset class. Using the stock market as an example again, it would not be prudent to only buy stocks in oil and gas; rather, an investor who wants to diversify their stock holdings would buy stocks across different, unrelated industries.
Now that we have a base for what portfolio diversification is and why it’s so important, let’s dive into a few strategies to keep in mind when approaching diversification.
Quality trumps quantity
Having a properly diversified portfolio doesn’t just mean having a large number of investments. When we say “quality,” that can mean investments that are already valued highly (such as a public stock) or those whose value is in their potential for growth, such as an early-stage startup that is gaining traction. Ideally, a diversified portfolio will have some of each, though their allocation may vary depending on the risk tolerance of the investor.
Add variety through alternative assets
Adding alternative assets to a more traditional investment portfolio of stocks, bonds, mutual funds, etc., can be a great way to diversify. Alternative assets include real estate, venture capital, private equity, and hedge funds, to name a few. While these types of investments do carry more risk than traditional asset classes, their fluctuations are oftentimes less correlated with those of traditional asset classes, such as publicly-traded stocks.
Approach trends with caution
Investing in the hot commodity of the moment may be tempting, but take caution with how much you’re allocating to trends. Just because something is hot on the market, doesn’t necessarily mean it’s best suited for your portfolio’s specific needs and goals. That isn’t to say you should avoid trendy investments entirely – rather, view them through a critical lens before making any decisions.
Be in-the-know about the industries you’re in
The more informed you are about the industries in which you’ve invested, the better. Staying up to speed can make it easier to identify when you should ride out a rough patch or when it’s time to wash your hands of an investment. The more you know, the better decisions you can make.
Don’t be afraid to rebalance
Once you’ve determined how you’d like to allocate your portfolio, it’s important to make sure it remains balanced. Rebalancing involves selling and/or buying one type of asset in order to maintain your desired asset allocations. When it comes to how often you rebalance your portfolio, there really is no one-size-fits-all approach. If you check in on your portfolio too infrequently, it could get knocked out of balance. Conversely, if you check in on your portfolio too often, you run the risk of overcorrecting in the face of normal market fluctuations. Some investors may choose to rebalance quarterly or annually; however, there are many other reasons why an investor may need to revisit their portfolio. Age, life events, and liquidity needs are all common reasons to rebalance. Generally speaking, if the risk level of your investments isn’t consistent with your overall portfolio goals, you may need to rebalance.
Putting it all together
One certain truth about building and diversifying your portfolio is that there is no single formula for success. There are endless different ways to structure your investments based on personal preferences, financial goals, life stage, and more.
While there are no hard rules, we hope that you can keep these five simple tips in your back pocket as you manage your investment portfolio.
If you want to learn more about portfolio diversification and risk management, check out this blog. Interested in adding startup investments to your investment portfolio? Browse our current offerings.