Portfolio diversification is a method of investment that is based on the spread of investments in different asset classes, industries and geographic regions to decrease the risk. Though diversification is not a money-making scheme or a way to prevent losses, it can be a good tool for you to spread the risk of your whole portfolio. This manual will discover the advantages of diversification and also present the practical steps for diversifying your stock investments.
The Benefits of Diversification
Diversification is usually called the only free lunch in investing, because it may raise the returns and at the same time lower the risk. The diversification of your stock portfolio will lower the effect of the bad performance of any single stock on your whole portfolio. Moreover, diversification can give you a chance to have different sectors and industries in your portfolio and thus, you can get the profit from the growth of different areas of the economy.
Review the Investments You Already Have
Before starting to diversify your portfolio, you should first look at your existing investment portfolio. Estimate the variety of your investments in sectors, industries and geographical areas. Recognize the spots where you are too much invested and then think of a way of spreading your investments more evenly.
Diversification Strategies in Different Industries and Sectors
The other method to make all stocks more diverse is to distribute them among different industries and economic sectors. For instance, instead of putting all the eggs in one basket and investing only in technology stocks, try to diversify your portfolio and add some stocks from healthcare, finance, consumer goods and other sectors. Thus, if one sector is in a slump, your entire portfolio won’t be so hit.
Geographical Diversification
Apart from spreading your investments between the industries, it is also wise to invest in stocks from different regions of the world. This in turn will be a plus to your portfolio in case the local economy is on a decline. In this case, if the economy in one country is the one that is struggling, stocks from the other countries may still be doing well, therefore acting as a buffer against the losses.
Incorporating Different Asset Classes
Diversification should not only be in the stocks. You should also think about adding other types of assets like indices trading to your portfolio like bonds, real estate and commodities. Each asset class has its own risk and return features, thus by diversifying among asset classes, you can also lessen the risk and probably increase the returns.
The Role of Alternative Investments
Besides the usual investments, alternative assets such as hedge funds, private equity and cryptocurrencies can be a great help in diversifying your portfolio. These alternative investments usually have a low correlation with traditional stocks and bonds, that is, their performance may not be closely related to the whole market. The addition of alternative investments is a way to lower the risk of your whole portfolio and at the same time increase its diversification.
Hedge Funds
Hedge funds are investment funds that employ different techniques to get profit for the investors. This strategy can be long and short positions, leverage and derivatives. Hedge funds are usually regarded as a rival to traditional mutual funds, providing more options and probably a higher return. Though hedge funds are risky and usually need a greater minimum investment than mutual funds, they can be a source of diversification and may even improve the performance of the whole portfolio.
Private Equity
Private equity is a type of investment in which a person or a group of people invest in companies that are not listed in the stock market or buy out publicly traded companies to make them private. Private equity investments are usually not liquid and they demand a long-term commitment, however, they can give you higher returns than the public equity markets. Private equity investments can be a way of diversifying a portfolio by giving a chance to get access to sectors and industries different from the ones provided by the public equity markets.
Cryptocurrencies
Bitcoin and Ethereum are the two main cryptocurrencies that have been considered as a new asset class which is prone to have high returns but at the same time, it is also very volatile. Cryptocurrencies are very speculative and risky but on the other hand, they can be a diversification tool because they are not related to the traditional financial markets. A little part of your portfolio can be allocated to cryptocurrencies which will help to diversify the risk and probably will increase the total return.
Rebalancing Your Portfolio Regularly
After you have diversified your portfolio, you have to often rebalance it to keep your desired asset allocation. Rebalancing is a process of purchasing and selling assets to restore your portfolio to the originally set allocation. This can be used to avert that you still profit from diversification in the future.
Common Diversification Mistakes
Though diversification is a strong strategy, there are some common errors that people make when they try to apply it. The most common error is to over-diversify, that is, to put your money in too many places. This could be a way of diluting the effect of your best-performing investments and thus decreasing the total return. The second error is over-concentrating or putting too much in one asset class or sector. This will make your portfolio to be more at risk if that asset class or sector underperforms.
Diversification is not a one-off thing but a process that goes on and on. Your diversification strategy should be adjusted as the financial goals and market conditions change. Through frequent inspection and the correction of your portfolio, you can make sure that it is well-diversified and that it has the same investment goals as you.
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