· How does diversification reduce risk?
· Various methods to diversify
· Calculated diversification?
· How beginners can diversify
Diversifying your portfolio is one the most common ways to reduce the risk of your overall investment portfolio.
How does diversification reduce risk?
A diversified portfolio reduces risk by not being concentrated in one specific area of investments. For example, if the manufacturing industry is performing poorly, you have technology and pharmaceutical stocks that could be performing well to offset the investment losses with your manufacturing investments.
In addition, certain asset classes have more risk opposed to others. Well established blue-chip stocks like Apple can provide a steady dividend income stream and a small-cap growth stock has it’s risks but a potential for large returns.
You do not want to be heavily exposed in one area, especially if one of your priorities is capital preservation.
Diversification of your portfolio can occur in various ways such as:
· Investing in different asset classes such as Stocks, Bonds, REITS and Commodities
· Investing in Indexes, ETFs, Mutual Funds and Hedge Funds
· Investing across various industries and sectors
· Investing in different companies within a specific industry or sector
· Investing in different geographic areas and different exchanges internationally
· Making investments that react to business cycles and political events differently
Overall, I recommend committing to conduct due diligence to ensure that you are not blindly selecting investments just for the sake of diversification. True diversification is having two different investments that are not correlated to each other in terms of how they perform based on certain factors.
For example, let’s say the fed is looking to raise rates and you have investments in the financial services industry and in retail. An increase in rates may make the financial services industry more profitable because they are able to receive more interest income, while retail will become less profitable because it becomes more expensive to borrow money and consumers may decrease their spending.
The most complicated and calculated way to diversify is to do statistical modeling to determine what is the optimal level of diversification for your portfolio and then make investments based off this computation.
How can beginner investors diversify?
For beginner investors with a lot less capital and experience, an easy and low-cost method of diversification would to just invest in various indexes, ETFs and Mutual funds. It can be very expensive at first and difficult to select a portfolio of individual investments that are diversified properly.
In addition, hiring a registered investment advisor and portfolio manager can guide you in proper portfolio diversification based on your investments needs. This is probably the safest way to ensure that you are investing correctly, but may be costly in term of the fees that you have to pay.