When building an investment portfolio, diversification is an essential part of managing investment risk. In this blog, we will review the basics of portfolio diversification, including why it is important, as well as the different methods of portfolio diversification that can be used to help minimize overall investment risk.
What is portfolio diversification?
Risk is inherent to any type of investment, though some assets may carry higher or lower levels of risk than others. With investing, higher risk is generally associated with the potential for higher reward. However, for the prudent investor, there is a balance to be found between lowering investment risk and working to maximize potential for investment return. That’s where portfolio diversification comes in.
Portfolio diversification is an investment strategy tool that is meant to help minimize overall portfolio risk by creating a portfolio of investments with uncorrelated risks and returns. Ideally, over the long term, effective portfolio diversification can help stabilize possible returns. Think of it as way to avoid putting all of your investment eggs into one basket.
Portfolio diversification is all about adding variety to your investment portfolio. By investing in assets or industries with little correlation, you improve your odds of mitigating the overall damage to your portfolio if one specific sector takes a big hit.
Different ways to diversify your portfolio
Diversifying by company, industry, asset class, geography, and time horizon are five common areas investors may focus on to add variety to their investment portfolio:
This one should be a no-brainer, but it’s never advisable to invest in just one or even a few companies and expect positive results. This is a recipe for disaster. A well-diversified investment portfolio will be made up of many investments, with no single company making up the bulk of your allocation.
In addition to investing in a wide variety of companies, investing across multiple different industries or sectors is important too. Whether it be real estate, information technology, and/or manufacturing (to name a few options), disperse your investments across different spaces within those areas.
Depending on the present economic situation, different asset classes (stocks, bonds, real estate, alternatives, cash, commodities, etc.) can perform differently. When the economy is booming, stocks often perform well. During an economic downturn, bonds generally become a safer bet. A healthy portfolio will have a mix of different types of asset classes, though their allocation will likely need to be adjusted over time as an investor ages or as their investment goals change.
Another way investors can diversify their portfolio is by investing across borders. No single economy is going to outperform indefinitely, but having investments in a variety of markets can add a layer of diversification protection.
Diversification across time horizons can also be an effective strategy. Time horizon refers to the time in which an investor can hope to see a return from their investment. Investments that have a long time horizon include startups or real estate, while assets such as high interest bonds and growth stocks have an intermediate time horizon.
Diversification isn’t a set it and forget it activity–once you’ve landed on a good target mix, it’s important to periodically check in to see if it needs rebalancing to realign with your overall goals and strategy.
There isn’t a single best to diversify your portfolio, and it may take some trial and error to determine the best mix for you. Your investment portfolio should be structured to suit your unique personal preferences, life stage, financial goals, and more. Portfolio diversification can feel like a big task, but we hope that these considerations help as you manage your investment portfolio.
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The information presented here is for general informational purposes only and is not intended to be, nor should it be construed or used as, comprehensive offering documentation for any security, investment, tax or legal advice, a recommendation, or an offer to sell, or a solicitation of an offer to buy, an interest, directly or indirectly, in any company. Investing in both early-stage and later-stage companies carries a high degree of risk. A loss of an investor’s entire investment is possible, and no profit may be realized. Investors should be aware that these types of investments are illiquid and should anticipate holding until an exit occurs.