“Don’t put all your eggs in one basket”, goes the old adage. Based on your goals you may have allocated your investment into various asset classes such as equities, fixed income, insurance and commodities. But if you do not diversify within each asset class, the exercise, according to analysts, is sub-optimal.
How Diversification Works
Stocks do well when the economy grows. Investors want the highest returns, so they bid up the price of stocks. They are willing to accept a greater risk of a downturn because they are optimistic about the future.2
Bonds and other fixed income securities do well when the economy slows. Investors are more interested in protecting their holdings in a downturn. They are willing to accept lower returns for that reduction of risk.3
The prices of commodities vary with supply and demand. Commodities include wheat, oil, and gold. For example, wheat prices would rise if there is a drought that limits supply. Oil prices would fall if there is additional supply. As a result, commodities don’t follow the phases of the business cycle as closely as stocks and bonds.4
Portfolio Diversification
Portfolio diversification concerns with the inclusion of different investment vehicles with a variety of features. However, the strategy can bring benefits to an investor only if the investments included in the portfolio include a small correlation with each other. A small correlation indicates that the prices of the investments are not likely to move in one direction.
There is no consensus regarding the perfect amount of the diversification. In theory, an investor may continue diversifying his/her portfolio if there are available investments in the market that are not perfectly correlated with other investments in the portfolio.
An investor should consider diversifying his/her portfolio based on the following specifications:
Types of Investments
Include different asset classes such as cash, stocks, bonds, ETFs, options, etc.
Risk levels: The portfolio generally should consist of the investments with minimal levels of risk. Investments with dissimilar levels of risks allow the smoothing of the gains and losses.
Industries: Invest in companies from distinct industries. The stocks of companies operating in different industries tend to show a lower correlation with each other.
Foreign Markets: An investor should not invest only in domestic markets. There is a high probability that the financial products traded in foreign markets are less correlated with the products traded in the domestic markets.
3 Tips for helping you with Diversification
1. Spread the Wealth
Equities can be wonderful, but don’t put all of your money in one stock or one sector. Consider creating your own virtual mutual funds by investing in a handful of companies you know, trust and even use in your day-to-day life.
2. Consider Index or Bond Funds
You may want to consider adding index funds or fixed-income funds to the mix. Investing in securities that track various indexes makes a wonderful long-term diversification investment for your portfolio. By adding some fixed-income solutions, you are further hedging your portfolio against market volatility and uncertainty. These funds try to match the performance of broad indexes, so rather than investing in a specific sector, they try to reflect the bond market’s value.
3. Know When to Get Out
Buying and holding and dollar-cost averaging are sound strategies. But just because you have your investments on autopilot doesn’t mean you should ignore the forces at work.
Stay current with your investments and stay abreast of any changes in overall market conditions. You’ll want to know what is happening to the companies you invest in. By doing so, you’ll also be able to tell when it’s time to cut your losses, sell and move on to your next investment.