Building your portfolio? Follow these steps to make sure it's diverse.
Today, investing means different things to different people. For some, it's as simple as putting their money into an RRSP or TFSA and sitting back to watch it grow. But others see it as a means of achieving specific goals and financing their way to a secure financial future.
What Is Diversification?
Before you start your investment portfolio, it is good to understand what it means and why you need diversification. While this is something that you do not need to understand as a beginner, as you move up the ladder of investment, you definitely should.
Diversification is the act of spreading your portfolio in many different kinds of assets.
Therefore, allocating your money will help you to hedge your bets when investing.
For example, instead of investing all your money in one company, you should consider investing your money in different companies, especially those of different sizes and of different sectors.
This mitigates risk because if one company goes down, it does not automatically mean that all of them will follow.
The best thing about diversification is that with this strategy you can still make high profits, and your risk is limited.
Now that you know what diversification is, we can proceed to examine how you can diversify your portfolio.
There are two ways to go about it: “Mix and match” and “Push and pull”. Both have their own advantages and disadvantages.
Mix and match means that you create a diversified portfolio by mixing various assets to the extent that it is possible. This asset allocation is not permanent but fluid.
How Can You Diversify Your Investments?
We all know that investing is an important aspect of your financial future. After all, your portfolio has to last for decades into the future. And we also know that you should diversify your portfolio. But diversification means different things to different people. So how can you diversify your investment portfolio in a way that doesn’t benefit one particular asset?
Cash and Fixed Income
Cash is the most literal interpretation of diversification. But it doesn’t reap a lot of the rewards that other investments can. If you keep your cash in a bank account or a money market fund, you can generally expect a 1% to 3% return. That’s not a lot. That being said, cash is crucial to your financial health because it gives you options. If the market crashes, you have money left in savings to pay for unexpected expenses. If you need to invest in other ventures, you should have enough extra cash to do so. Most experts recommend having 1-2 months of income set aside in a high-yield account.
Fixed income has the same advantages as cash but also comes with a bit more risk and a bit less return. Bond prices are linked to other interest rates, so they vary in value with other rates and with market conditions. That’s why many economists say that the best way to diversify your portfolio is with a high yield bond fund.
The term "asset allocation" means the process of dividing your retirement savings between different investment and saving vehicles.
Understanding asset allocation is the first step in diversifying your retirement portfolio, because it will let you decide how to allocate the assets you already have.
Some of the questions you'll need to answer are:.
What is best way to diversify my portfolio?
How can investing in index funds lower risk?
What's the difference between a mutual fund and an index fund?
How to Get Started with Asset Allocation
Before you can build a reliable investment strategy, you need to understand the basics of diversification, as well as investment risk.
They limit the amount of money you're putting toward risky investments, and they lower the amount of risk you're going to take on.
When you diversify your investment portfolio, you're making sure that your money is spread out over different sectors.
That means you may have some of your investment portfolio in bonds, and some of it in stocks, and then some of it in mutual funds and some in exchange-traded funds.
Diversifying is usually the smartest way to go, but again, it depends on how much risk you think you can safely take…and how much risk you need to take.
Invest in a Mix of ETFs and Mutual Funds
When it comes to diversifying your investment portfolio, there are two ways to go about it:
Invest in different companies across different sectors.
You can create this diversification by investing in different companies across different sectors.
Invest in different kinds of stocks across different sectors.
Here, you have the option of either investing in different stocks across different sectors or portfolios of stocks (which is also known as a mutual fund).
ETFs span multiple sectors and industries.
ETFs are baskets of stocks from different sectors.
ETFs are baskets of stocks in different sectors.
ETFs are market-weighted indexes, which means the ETF itself has a higher weighting on stocks that determine the direction of the market, and lower weighting on companies with less impact on the market.
So, for example, if the S&P soars in value, the ETFs holdings also soar in value because the stocks on the rise are more than likely in the ETF.
ETFs give a more passive approach to investing.
An investor should buy ETFs and maybe hold them for several months or even years.
They should not worry as much about what the company in the ETF does or about when to sell it.
Instead, they should focus more on the long term trends of the market.
Invest in Foreign Companies and Assets
Selecting a portfolio of stocks or investment funds that are not all from within the same country ensures that you are diversifying your investments and making them as stable as possible.
Investing in foreign companies can be a good way to diversify your portfolio. However, you may not be able to find the shares of a certain foreign company in your local country. So that means you may need to invest in a foreign listed fund that is widely traded and thus easy to buy and sell.
You can also choose to invest in foreign real estate. Doing so can be a great way to diversify your portfolio, especially if you're located in a country where the cash flow in the real estate market is slow. Investing in real estate abroad may allow you to join in on high cash flow markets instead.
Or you can invest in foreign adventures. This way, you get to travel around the world, see interesting places, meet new people, and enjoy a new culture.
For some people, this may be a great way to get away from their daily hectic schedule. For others, they may already be traveling to different countries already on business, so increasing their holdings in this way may provide them with an extra cash flow on the side.
Vary Your Investments by Company Size
If the majority of your investments are in large cap stocks, it is time to start thinking about diversifying your investments by company size. Because you are in the majority with your large cap funds, you have little say in how the companies are run. If the majority owners (the shareholders) vote for it, a corporation can do pretty much whatever they want.
When you own small cap stocks, or mid cap stocks, you have a little more say in how that company runs. You are no longer a minority but rather a small fish in a large pond. You want to be a bigger fish in a smaller pond. You want to be the whale in the tuna cannery. When everything is equal, you tend to work with people that are just like you. This will give you more power as a shareholder – the most powerful voting issue in the country.
The Downside of Diversification
A portfolio of many different companies exposes your money to a lot of different kinds of risk.
If one of those companies goes bankrupt, your wealth is hurt.
If one of those companies is so profitable that they are too focused on growth, and thus neglect their existing customers who they already have, you get hurt.
If the economy is doing really poorly, you lose money. It's all of those things mixed together.
Diversity Is Still the Safest Investing Strategy
Diversification is still the safest investing strategy. But it’s a strategy that you don’t need to use for your entire portfolio.
In order to diversify, it’s not necessary to divide your investments among various stock companies, bond issuers, or investment managers. In fact, you don’t need to put your money into any “thing” at all in order to diversify your portfolio.
A single investment, diversified over a number of years, is a way of diversifying. That can be a single stock, bond, mutual fund, or some other investment. What makes the diversification is that it’s not all in one place.
Let’s say you invest in Coca-Cola stock. That’s one stock, and you’re putting all of your money into it. It’s risky – you could lose all of your money. But if you invest that money in Coca-Cola stock over a number of years, then you’ll become an investor in Coca-Cola.
Some people suggest that you buy five different stocks, such as different kinds of companies. That’s not diversification.