Edited by Sandy Yong
When managing your investment portfolio, diversification is a key strategy to utilize. The advantages are that you can reduce volatility and risk, and it can be fun to research while diversifying.
If you’re new to investing, it’s normal to feel nervous or intimidated about putting your money into the market. And rightfully so. Without much experience, it’s easy to overlook costs and fees. If you’re not careful, they can add up quickly due to more trading and transaction fees.
Your risk profile and tolerance will help dictate your mix of investments. There are several ways in which you can diversify—let’s take a look. By learning these methods, you can become confident in building a balanced investment portfolio.
Asset Classes
One of the best ways to spread out your risk is by investing in different asset classes, including stocks, bonds, real estate, and commodities. That’s because they don’t all behave the same way. So, when one isn’t doing so well, another might help to prop up your portfolio.
Different asset classes are affected by overall economic and market conditions in different ways. If you only invest in one type of asset, you might take on more risk than you need to and miss out on other opportunities for returns.
Ideally, you’ll want a good mix of investment types to help diversify your portfolio and give you a wide range of exposure.
Stocks
Stocks (also known as equities) let you have a slice of a company’s growth—but it may be a rollercoaster ride. When you buy a stock, you become a shareholder, technically speaking. One year, you could see double-digit growth. The next year, it’s slowed down.
In essence, if the company does well, you could receive dividends or earn interest. However, you may also lose money if it doesn’t. Let’s look at different types of stocks, various industries, and company sizes.
Types of stocks
Within your stock holdings, you can also diversify your risk. You can purchase a variety of stock types with different risk profiles:
- Blue-chip stocks are market leaders and the biggest companies. Examples include American Express, Coca-Cola, and Apple.
- Income stocks issue high dividends regularly. Companies such as IBM and Verizon are considered income stocks.
- Growth stocks focus on reinvesting profits to sustain high levels of development, like Tesla and Nvidia.
- Cyclical stocks tend to rise and fall with economic cycles, as in the automotive and entertainment industries.
- Defensive stocks stay strong during slow economic periods because consumers need their offerings, even in downturns (like Walmart and Procter & Gamble).
- Healthcare, utilities, and consumer staples (such as household goods) are industries that include defensive stocks.
Investing across different industries
Another way to diversify your stock portfolio is to invest across industry sectors. There are 11 common sectors:
The first sector is Information Technology, which includes technology products and services such as cloud computing, hardware, software, and semiconductors. Then there’s Health Care, which encompasses medical services companies, senior housing, and biotechnology. A key industry is Financials, such as banks and other financial institutions.
When consumers cut back during economic downturns, the Consumer Discretionary sector includes products and services such as automobiles and luxury goods. This ties into Consumer Staples. These are goods that are needed regardless of economic cycles, such as food and household items.
An essential industry is Communication Services. Cell phone, landline, and cable companies are common examples. We also rely on Utilities like companies that provide electricity, gas, water, and other related services. Another valuable sector is Energy, including oil, natural gas, renewable, and solar companies.
A popular investment is in Real Estate, such as companies involved in property ownership, operations, and management. They could be focused on residential or commercial properties. Another vital sector is Materials. Think of companies that are engaged in the discovery and refinement of raw materials, such as metals, chemicals, and forestry products (like paper manufacturers). Lastly, let’s not forget Industrials, which manufacture goods that don’t require raw materials, such as farm equipment. Aerospace, machinery, transportation, and logistics are other examples.
Market Capitalization
Diversification by company size or market capitalization (market cap) can reduce volatility as well. Market cap is a company’s market value. It’s calculated by multiplying the number of outstanding shares by the current stock price. Market size can be classified as:
- Small-cap stocks are companies with a market cap of $300 million to $2 billion.
- Mid-cap stocks have a market cap of $2 billion to $10 billion.
- Large-cap stocks are companies with market caps of $10 billion to $200 billion.
What’s great about large-cap stocks is that they provide stability and regular dividends. On the other hand, small-cap stocks offer higher returns, but you have to have a strong stomach, as they come with greater volatility and risk. For the average investor, a good strategy to consider is to invest across all market-cap categories.
Bonds
Bonds are loans you make to companies or governments, and they pay you fixed interest, often every six months. Bonds usually the calmer part of a portfolio since they have lower risk than stocks. What’s the tradeoff, you ask? Well, they have lower returns. When diversifying your bond portfolio, you can purchase bonds with different maturity dates, bond types, bond sectors, and bond risks.
To diversify using maturity dates, you can buy a mix of short-term, intermediate-term, and long-term bonds. You can also choose from different types, like corporate, U.S. government, or municipal bonds (issued by cities and towns).
Similar to stocks, you can also purchase bonds across a variety of industry sectors. Finally, you can mix your bond portfolio with different risk ratings.
Real Estate
You probably played the classic Monopoly board game. So, as you probably know, real estate is most commonly associated with land and property holdings. They’re appealing because they provide ongoing income and profits through appreciation. Here’s the catch. These require large capital investments—which not everyone has. Of course, it’s not entirely passive as it requires a more hands-on approach. So, if you’re just starting and don’t have the funds to purchase a property, there are other ways to get started.
A Real Estate Investment Trust (REIT) is a holding company that owns and manages a portfolio of real estate. This can include shopping malls, strip malls, commercial real estate, housing developments, land, and retirement communities.
Most REITs are listed on major stock exchanges. Unlike being a landlord, the main benefit of owning a REIT is earning income passively. You can also look into mutual funds or ETFs focused on real estate. Just be sure to check the fees, such as the Management Expense Ratios (MERs), so you know what it costs to own these investments.
Commodities
Commodity trading, such as gold or silver, can help protect you against inflation. In times of rising prices, commodities usually outperform stocks and bonds. In the past year, commodities have been very popular amongst investors—but they can also be volatile.
You can invest in commodities in several ways: commodity ETFs, commodity mutual funds, buying the commodity directly (such as gold or silver), futures trading, and purchasing individual stocks, such as a gold mining company.
International
The last way to diversify is to invest in other countries (outside the United States). This enables you to spread your risk across multiple worldwide economies and can help protect you against any one country’s economic downturns.
To do this, you can invest internationally by buying American Depository Receipts (ADRs), which enable U.S. investors to own and trade foreign stocks. You can also purchase internationally focused mutual funds and ETFs that focus on global markets.
You could also buy stocks directly from foreign markets, but this can be tricky due to time zone differences, currency fluctuations, varying rules, and taxes.
Before you invest globally, there are risks to be aware of. For one, international stocks can experience changes in currency values or political issues (such as an ongoing war or tariffs). Other factors, such as currency swings and new trade laws, can impact how much you earn from these investments.
Diversification is a key component of successful investing strategies. As your portfolio and personal experience grow, you can try more sophisticated strategies.
FAQ
What’s the easiest way for beginners to diversify?
Index funds and ETFs (Exchange-Traded-Funds) offer instant diversification by holding a broad basket of investments in one fund. As an example, a basic mix of a total stock market fund, a bond fund, and an international fund can give you a well-diversified portfolio. For the everyday investor, all-in-one ETFs (also known as asset allocation ETFs) are also a simple way to diversify and have low fees.
What are alternative investments?
These include assets such as private equity, hedge funds, commodities, and collectibles, which can further diversify beyond traditional stocks. Cryptocurrency has also gained in popularity in recent years. But it’s not for the faint of heart. Due to high volatility and a speculative nature, investors should be cautious and consider allocating only a small portion to their portfolios. So, invest only the money you’re willing to lose.
Is diversification the same as asset allocation?
No, they’re different. Diversification is how you spread your risk by choosing different types of investments. Meanwhile, asset allocation is about deciding how much to put into each type of investment.
Does diversification guarantee I won’t lose money?
No. Diversification reduces risk, but it doesn’t eliminate losses, especially during broad market downturns. Nothing in the stock market is guaranteed. As long as you maintain a long-term perspective, you can ignore daily stock market fluctuations.
What’s the biggest mistake investors make with diversification?
A common mistake among investors is believing they’re diversified when they hold similar assets (like having multiple funds with overlapping holdings). For example, an investor may own U.S. consumer staples that include the exact same companies in their S&P 500 fund.
What is rebalancing, and how often should I rebalance my portfolio?
Rebalancing basically means adjusting your portfolio back to your target allocation by buying or selling assets. Most investors rebalance once or twice a year, or during major market shifts when allocations drift significantly from their targets. For most people, periodic reviews are sufficient, as over-managing can lead to unnecessary costs.
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