5 Things a Financial Advisor Would Tell You About Portfolio Diversification
It is a well-known fact that portfolio diversification is one of the most important things to undertake as part of your financial planning. Proper diversification can reduce the risk component on your portfolio and offer you better returns over time. However, there is also a downside of diversification. In fact, over diversification can cause significant damages to your portfolio and overall goals. This is why it is recommended to consult a financial advisor to find the best opportunities for diversification for your portfolio.
If you consult with a professional, here are 5 things that a financial advisor will tell you about portfolio diversification.
- Diversification spreads your risk rather than eliminating it
- Over diversification is just as bad
- Pick the right asset classes and diversify regularly
- With diversification, your portfolio should show a range of performances
- It is crucial to invest in international products as well
A lot of investors assume that diversification will give them a risk-free portfolio. In essence, it is essential to understand that diversification is only a means to reduce risk. There will always be some degree of risk involved in your investments. When you pick different stocks and assets to diversify, you distribute this risk across industries or sectors. For instance, if you own stocks in a company in the pharmaceuticals industry, some in technology, and a few others in the food industry, you will immune your portfolio against market forces to a great extent. It is highly unlikely for all industries to react in the same manner. So, if the stocks in technology go down, you will be able to cover these losses from your stocks in pharmaceuticals or vice versa. A financial advisor will not only advise you to diversify but also offer guidance on how to diversify and what to expect from your choice of investments.
Moderation is required in every sphere of life, and financial planning is no different. While all financial advisors emphasize on the importance of diversification, they will also warn you against the perils of over diversification. When you over diversify, you expose yourself to additional risk. This backfires in the long run. Moreover, managing and keeping up to date with so many investments is also a challenging task. Some investments need careful monitoring to time the market. With so many investments in your net, you are bound to get confused and ultimately miss out on crucial opportunities. Buying similar stocks in the name of diversification also leads to repetition and nothing more. So, while diversification is essential, over diversification is not. A financial advisor will suggest that on average, you should aim to keep a minimum of 20 and a maximum of 30 investments on your portfolio.
The most common understanding of diversification is to spread your money across industries. While most investors carry this out with great dedication, they forget that diversification is not limited to industries alone. It is equally vital to diversify across asset classes. For instance, picking only stocks from four different industries will reduce the risk element only partially. So, you must also look at different asset classes, such as bonds, equity, cash and cash equivalents, exchange traded funds (EFTs), etc. You can also consider small-, mid-, and large-cap stocks. Putting your money in different types of asset classes will offer the real benefits of diversification.
A financial advisor will not only advise you to put your money in varied asset classes, but also impress upon you the need to diversify in periodic intervals. Many people think that diversification is a one time activity. However, just as any other goal that changes with life, the need for diversification will also alter from time to time. You must regularly revisit your portfolio and shuffle around products as you see fit, depending on your goals and needs at the time.
While the purpose of diversification is to bring your risk to the minimum possible degree and increase your returns to the maximum possible degree, it is not possible for your portfolio to always yield profits. The markets are dynamic, volatile, and unpredictable. As a result of this, most investments fluctuate between losses and gains. A sign of whether or not you have optimally diversified your portfolio is to see if your investments show a wide range of reactions to market forces. If all your investments react similarly, then your diversification is not effective as all your investments are responding to external forces in the same manner. While the end goal is always to earn profit and see the bar going up, inconsistency on performance along the way is a precursor to ineffective diversification.
Diversification should cross international borders. Although many people believe that in this age of globalization, diversifying in domestic stocks is as good as foreign stocks, you should not ignore the many advantages of global exposure on your portfolio. Foreign markets offer more opportunities for growth. They are also not exposed to the downturns of domestic markets. However, what most individuals do not know is that global diversification has its threats too. A financial advisor can offer you guidance on how to stay acquainted with all the changes in currency dynamics, foreign policies, and political, economic, and social changes in the country of origin as well as your own.
In addition to this, diversification may also be only suited to investors with a high net worth as it requires more flexibility and liquidity. This may not be suitable for all individuals and may actually pose a threat to some portfolios. A financial advisor can help you assess if you should be taking the plunge or not.
To sum it up
Diversification is essential to bring profits and gains. But it is also complicated and complex and requires professional assistance and guidance. While a majority of investors understand the relevance of not putting all their eggs in one basket, not many are able to carry this out with ease. This is why, when in doubt, you must reach out to a competent financial advisor to know more and for better recommendations.