Ten Tips for a Diversified Investment Portfolio
8th Dec 2021
Financial Advisor Insights
15 Min Read
Whether you are a seasoned or a first-time investor, one question that is likely to concern everyone is, how should I diversify my savings? Diversification is a crucial element of any financial strategy. Diversifying your portfolio is the most effective medium to reduce your investment risk. A well-diversified portfolio comprises a mix of different securities and investment vehicles (such as stocks, bonds, cash, government securities, alternative assets, etc.) that aim to limit the risk by restricting the portfolio exposure to any particular asset. The driving principle behind adopting a diversified investment strategy is that a portfolio with different assets, on average, will have low risk as compared to a portfolio with a single security investment. A diversified portfolio helps even out the market volatility; i.e., the gains in one security investment will phase out the losses from another security investment. However, a diversified strategy is effective only when the underlying portfolio investments are not correlated. To fulfill the objective of diversification, your portfolio securities should respond differently. In most cases, it is beneficial if the portfolio assets behave in opposing ways with market forces. You can maximize your returns and minimize risk by choosing to invest in securities that react differently to a particularly similar market event.
That said, diversification does not safeguard fully against loss. Nevertheless, as per financial experts, diversification is one of the most critical components for achieving your long-term financial goals, especially if you are saving for retirement. By diversifying your portfolio, you are avoiding the philosophy of putting your eggs in one basket. Note that the scope of diversification is not limited only to different asset classes, such as bonds, stocks, cash, alternative assets, etc. An optimally diversified portfolio requires you to invest across different asset classes and diversify among different industries and companies. For instance, you could choose to create a diversified portfolio of stocks, bonds, cash, and alternative assets. But even within stocks, it is advisable to invest across different industries and companies. So, you could choose to invest in stocks of airlines, technology, railway, digital technology, and other industries to ensure one can counterbalance the volatility in another segment. Further, looking for investment opportunities beyond your geographical boundaries can also be beneficial for your portfolio. For instance, investing in foreign stocks, such as Europe, India, etc., can help offset the volatility of U.S. stocks. If you require help in diversifying your investment portfolio, do consult with a financial advisor who can advise you on which securities to invest in.
Even though diversification is a proven investment strategy, it may have its limits. When it comes to systematic risks, such as risk associated with inflation, exchange rates, political unrest, interest rates, war, etc., these types of risks do not have a bearing on any particular industry or company. Hence, it is not possible to eliminate these risks through diversification. However, even in this regard, an optimally diversified portfolio, especially one with foreign stock holdings, may perform better than a non-diversified portfolio.
Here are ten tips to keep in mind while diversifying your portfolio:
- Be careful of your asset mix: Your asset mix typically governs your diversification strategy. If you want an ideally diversified portfolio, it is important to focus on your asset mix. Typically, you could think of a perfect balance between stocks and bonds. While stocks offer the high-returns with high risk, bonds are typically more stable and low-risk investments. To minimize your portfolio risk, you can divide your assets between these two options. For this, it is vital to know the amount of risk you can accept as an investor. Essentially, your asset distribution depends on your risk tolerance and age. At a younger age, you can include more stocks in your portfolio and aim for high returns. You have a long time to absorb short-term volatility and overcome any market losses.
Alternatively, if you are close to your retirement age, it is advisable to invest in more secure assets like bonds that assure safety of capital and a reliable income stream. Another medium of allocating your assets is by following the age formula. You can subtract your age from 100, and the answer can be the suitable percentage of stocks in your portfolio. For instance, if you are 30 years old, your ideal stock allocation (100-30) will be 70% in stocks and 30% in bonds. However, if you are 60 years old, your perfect asset allocation would be 40% in stocks and 60% in bonds. Even when investing in stocks, aim to distribute your holdings across different industries and companies. Choose large-, mid-, and small-cap companies of different sectors like energy, pharmaceuticals, technology, etc., to create a diversified portfolio. In terms of bonds, focus on including some government debt instruments like Treasury bills and a few corporate bonds, and related debt securities. Apart from creating a portfolio with stock and bond investments, you should consider including alternate assets to generate unrelated, high-growth prospects. Some alternate assets you can think of adding to your portfolio are real estate, commodities, natural resource equities, hedge funds, startups, private equity, precious metals, etc.
- Assess qualitative risks and hold the right number of stocks: Irrespective of your age, financial experts suggest investing at least some portion in stocks. However, a guiding principle when investing in stocks is to know the qualitative risks of stocks before investing. Merely choosing stock investments that generate high returns is not the best approach for diversification. The objective is to evaluate the stock on specific parameters to know the risk scale. Some of these factors include the stability of the company, its financial standing, the integrity of the management, brand value, market image, risk management practices, corporate governance, business growth aspects, compliance with rules and regulations, etc. Knowing the qualitative risks will help you find the right stock holdings for your portfolio. Despite understanding the stock risks, financial experts recommend holding only the right number of stocks. Filling your portfolio with excess stocks can do more harm than good. Ideally, you can hold 50-60 stocks at a maximum in your portfolio and can diversify within this group across different companies and industries. However, it is advisable to not invest a large sum in one or a few select companies. Concentrated stock investments can expose you to higher losses rather than high returns.
- Avoid overlapping investments: When diversifying, the objective is to not invest across different asset classes. The idea is to create an asset distribution strategy that works well for your financial case. It is critical to think broadly and invest to tap the potential of different sectors. For instance, you can choose different funds like mutual funds, index funds, exchange-traded funds (ETFs), etc., to create a diversified portfolio. However, all these funds are investing in securities of a particular sector, say energy and oil. In this case, you are typically paying different fees for the same underlying assets. Instead, you can choose a single fund type and fully invest in it. Alternatively, you could select different funds but in various sectors. For instance, you can invest in mutual funds in the energy sector, index funds in pharmaceuticals, and ETFs in the technology sector. This will mean you do not create an overlapping investment portfolio, instead explore new sectors and create a well-diversified portfolio. Similarly, in the case of bond investments, it is not wise to only focus on a particular type of bond, such as Treasury Bills. The motto is to invest in different bond types, such as corporate bonds, government bonds, etc., to generate cross-related returns. Even in alternative assets, a diversified portfolio should focus on investments in different assets and sub-assets. For example, if you want to invest in precious metals, choosing two or more different metals is advisable rather than investing in one precious metal.
- Be wise with alternate asset investments: Alternate assets are a great medium to counterbalance volatility from stocks and bonds. Alternative investments have become a rage in the financial market recently, owing to their ability to create inflation-beating returns. Typically, these assets are unconventional assets other than stocks, bonds, and mutual funds. Alternate investments like precious metals, hedge funds, real estate, natural resource equities, private equity, commodities, etc., can offer high returns but also carry a high degree of risk. Hence, investing in these assets should depend on your risk tolerance and return expectations. If you do not want to invest directly in alternate assets like real estate and precious metals, you can opt for REITs (Real exchange investment trust) and metal ETFs. This will provide the much-needed diversification to your portfolio while allowing you to earn high returns at low risk. Further, alternate investments are a sound medium to counterbalance stock and bond investments. Alternate assets like real estate are known to provide stable returns, especially when stocks and bond returns plummet.
- Choose some preferred securities: Also known as hybrid securities, preferred security investments are a good medium to effectively even-out market risk. Hybrid securities possess characteristics of stocks and bonds and are issued by banks, insurance firms, and other authorized entities. These securities potentially offer higher returns than general equity, bond, and related securities. Hybrid securities provide fixed income and security of capital. However, their investment duration is considerably long, usually 30 years or longer. In some hybrid securities, you have an option to invest without a maturity date. These are perpetual securities that do not pay dividends instead allocate coupons to the investors. Financial experts recommend investing a small part in preferred securities to create a diversified retirement portfolio. These securities offer benefits like fixed and attractive returns, lower default chances, tax exemptions, reduced interest rate risk, and diversification. Income from preferred securities is treated as qualified dividend income. Hence, this income attracts a tax of 20% instead of the regular 37% on dividends. That said, investing in preferred securities adds more balance and security to your portfolio, but since these securities are long-term investments, it is best to consult a financial advisor to know how to split your investment portfolio.
- Hold some money market securities: Safe to say, money market securities do not provide growth prospects for your portfolio. But even these securities are necessary for an adequately diversified investment portfolio. Money-market securities are issued by the government, corporate entities, and large financial institutions and are required for the portfolio since they add liquidity and safety. Money market securities like certificates of deposits (CDs), commercial papers, money market funds, T-bills, bank acceptances, etc., are conservative investments that offer low risk and low returns. Investing in money market securities gives you short-term liquidity and allows you to offset considerably high-risk investments like stocks. However, such securities do not offer inflation-beating returns. Hence, it is not advisable to invest a significantly high portion of your portfolio in these assets.
- Opt for time-based diversification: If you aspire to achieve the ideal diversification level for your investment portfolio, you can consider the time-based investing strategy. In this strategy, timing and withdrawal of investment play a pivotal role. For instance, if you are investing for retirement, your asset choices will chase long-term gains rather than short-term profits. You can pursue time-based diversification by investing in assets that are expected to deliver returns or dividends at different times. One strategy that can help you deploy time-based diversification effectively is bond ladders. A bond ladder comprises a range of bonds with different maturity dates to reduce risk and provide an assured income stream. Structuring a portfolio per the bond ladder strategy implies holding a pool of bonds with varying maturity dates. For instance, you have $900,000 to invest in bonds. If you use the bond ladder strategy, you can divide your total amount into four maturity dates, such as two, four, six, and eight years. These maturity dates are set at a considerable gap to allow the bonds to earn significant returns before maturing. In a bond ladder approach, you can reinvest your matured bonds. So, after two years, when your first bond investment matures, you can reinvest the sum beyond the longest period on the bond ladder (eight years). Using the bond ladder strategy reduces risk by distributing your bond maturity dates across different periods. You can also potentially get higher returns than a general bond investment. Bond ladders also provide you liquidity and flexibility since you can structure the bond ladder to suit your financial requirements. This is especially beneficial for retirees who require a stable income source during retirement.
- Choose disciplined investments like SIPs: One aspect of diversification is choosing the right assets and sub-assets. However, another vital element of diversification is selecting a sound medium of investment. Mutual funds allow you to effectively diversify your portfolio. However, you can invest in mutual funds through two methods – lumpsum and SIP (Systematic Investment Plan). Choosing the lump sum mode means you buy a unit of mutual funds collectively at the given price. Alternatively, if you opt for SIPs, you contribute a pre-agreed sum in your mutual fund scheme at a predefined frequency for a specific period. This means every time you buy mutual fund units at a different price. This helps to even out high-low unit prices, increasing your chances of capturing positive market fluctuations and getting more units at low prices. This means your NAV (Net Asset Value) can potentially be higher in SIP than a lump sum. You can start a SIP with minimum investment. Over time, your fund grows exponentially, owing to the power of compounding. SIPs help you make a disciplined investor while reducing your investment risk.
- Understand the market and pick your moves wisely: Generally, you create a portfolio that aligns with your long-term goals. This is also the best investment diversification strategy. If you want a diversified portfolio that maximizes profits and reduces risk, focus on long-term objectives and avoid any short-term urges in investing. The objective is to adopt a buy-hold strategy instead of a constant sell-buy strategy. By adopting a buy-hold strategy, you invest in a security that offers long-term potential. This is exclusive of any short-term investments, such as money market securities, made solely for short-term liquidity. The buy-hold strategy allows you to create a stable portfolio that can withstand market fluctuations over time. You allow your investments to grow per their true potential. However, this does not imply you even hold on to long-time loss-making securities. There can be situations where the buy-hold strategy might not make financial sense. For instance, if a stock investment has been consistently leading to losses or a mutual fund is underperforming then the benchmark for a long period, then it might be the best to exit such investments. Long-term investing does not guarantee success. However, it does increase your chances of earning potentially high returns, provided you know when to make a move. Hold on to your investments if you have sound financial reasons to do so. Short-term losses or one-time low performance is not an exit indication. Long-term fluctuations, sustained losses, etc., might be sufficient reasons to pull out.
- Conduct periodic reviews and rebalance your portfolio: Diversification of your portfolio is an ongoing process. All financial experts recommend checking your portfolio and balancing various assets to ensure they align with your preferences. The fundamental basis for the review is to assess your financial goals, the primary purpose of investing, and your life stage. If your prime objective was to create a retirement nest egg, and you are a low-risk investor, a timely reassessment of your portfolio will ensure your asset allocation remains per your desired risk tolerance. Ideally, you should check your portfolio often, say once in six months. However, if that is not feasible, reviewing and rebalancing (if required) your portfolio at once a year is also a smart investment move. Timely portfolio reassessment also helps you keep a tab on the performance of your asset mix. In case the applicable diversification strategy is not fruitful, you can alter the plan to fulfill your goals. Diversification is not a failproof strategy. Hence, reassessing your portfolio can help you cover gaps that diversification tactics might have missed.
Irrespective of your financial goals, it is recommended to maintain a diversified investment portfolio in order to best protect your finances from market fluctuations. There is no standard answer to “How to make a diversified investment portfolio” Each investor has different diversification requirements. The ultimate goal is to create a diversified portfolio that reflects your investment preferences, risk tolerance, life stage, and financial goals. To tap the full potential of an optimally diversified portfolio, it is advisable to start investing early and to hold your assets for the long term, giving your investments a fair chance to reach their full potential.
You can also consult a financial advisor to pick the right investments for your needs and create a diversified portfolio in sync with your financial criteria. The financial advisor can assess your requirements and guide you on how to distribute your investments in the most effectually diversified manner. Use the free advisor match service and get connected with 1-3 fiduciary financial advisors that are suited to meet your financial requirements.