Smart investors create diversified investment portfolios. With diversified holdings, investors can weather the ups and downs of markets and spread risk.
Developing a diversified portfolio requires diligence, planning, and research. However, the hard work is likely to pay off for investors who put in the time.
Defining Portfolio Diversification
Diversification is a commonly used investment strategy. Investors spread their investments across different types of securities and other assets to lower the risk of market volatility. Another phrase for portfolio diversification is asset allocation. You’ll want to spread your available investment capital across asset types. Stocks, bonds, and cash are among the most common assets in a portfolio. Increasingly, investors are also using alternative investments as part of a portfolio diversification strategy.
One goal of portfolio diversification is to ensure there is minimal exposure to one particular asset class. That’s why healthy portfolios will blend disparate asset types together.
Diversification helps you improve your returns as well. By not putting all your capital in one asset class, you can protect against market volatility.
Portfolio diversification is different for every investor. Each of us has a different risk tolerance, preferences, and needs depending on where we are in our lives. These factors play into how people diversify and in which ways.
Benefits of a Diversified Investment Portfolio
More than anything, portfolio diversification minimizes the risk of loss. If one investment performs poorly, you can look to other investments that may not be subject to the same downturns. Overall, you’re more likely to reduce the possible losses in your portfolio. That’s why it’s unwise to concentrate all your capital in one investment type.
A diversified portfolio also lets you preserve capital. If you are close to retirement, accumulation may not be your top investment goal. Instead, you may want to preserve capital. With a healthy investment mix, you’ll be able to do just that.
Another major investment strategy is to generate returns. Diversifying a portfolio means you are less reliant on one asset class to generate desired returns.
You also want to be able to spend time on things other than reviewing your portfolio. A diversified portfolio means you’re no longer spending time just studying the stock markets, for example. You can focus on a long-term approach and not obsess over your portfolio every day with a diversified investment strategy.
4 Types of Assets for a Diversified Portfolio
You can diversify in many ways. But the most foundational is to a portfolio with many different asset types. Here is a closer look at 4 types of assets.
1. Alternative Investments
Increasingly, investors are turning to alternative investments for portfolio diversification.
Alternative investments are assets that do not include stocks, bonds or cash. In many cases, these investments are different in several distinct ways. They typically cannot be sold easily or converted to cash.
Alternative investments include assets not found in most investor portfolios.
Private equity is one alternative investment to consider. Private equity investments provide capital for private companies. In most cases, large venture capital companies provide private equity in various stages. However, individual investors can also commit to private equity as part of an investment strategy.
Private debt investors act in the same way that banks do, providing financing that supports a company. Companies often look for private debt investors when they need additional funds to fuel business growth. In exchange for the investment, companies pay investors to repay the initial loan and interest payments.
Cryptocurrencies such as Bitcoin are an increasingly popular alternative investment. Cryptocurrency uses blockchain technology, which records each transaction in a block. It also creates a chain to show the ownership timeline. Blockchain provides a secure, trackable way to manage investments.
Other alternative investments include real estate, commodities, and hedge funds.
2. Stocks
Stocks are purchased shares in publicly held companies, which provide shares in exchange for operating capital. Stock is traded on public exchanges, or stock markets, where prices fluctuate.
There are different types of stock. Some stock classes are only offered to employees, for example. These shares often come with restrictions, such as when they can be sold.
You can diversify your portfolio by holding stocks and holding different types of stocks. For one, you can purchase stocks in different industries or sectors. Intermingling stocks of various types helps you weather variances in one sector.
Another way to diversify your stock holdings is to look at size or market capitalization. Market capitalization is the total value of a company’s issued and tradable stock shares. Investors often choose a mix of large-cap, mid-cap, and small-cap stocks. Large companies tend to withstand market downturns more easily but have less growth potential. Smaller companies may have more volatile prices but can pay off richly in the long term.
3. Bonds
Bonds are loans that an investor makes, either to a government, a business, or a federal agency. In return, the investor receives interest payments over a specific term. Investors also receive repayment of the principal when the bond matures.
Bonds are secure investments but often at lower rates of return than stocks. You can buy bonds from many different entities, including the U.S. government, cities, international bodies, or corporations. There are also bond mutual funds and bonds issued by financial institutions, such as mortgage-backed securities.
Bonds help these agencies and governments support operations, build new buildings and improve infrastructure. Bond types include U.S. treasury securities, U.S. savings bonds, municipal bonds, and agency securities.
4. Mutual funds
Mutual funds are bundles of stocks, bonds, or other assets that are grouped together. Often, mutual funds share similar features, such as groups of stocks in an industry or of the same size.
Mutual funds by their very nature are a way to diversify your portfolio. They are designed to accommodate different investment strategies, risk profiles, and investor styles.
Mutual funds are managed by professionals who look to buy and trade stocks to improve their standing and returns. The funds pool money from multiple investors and invest those monies based on identified investment goals. These defined parameters and objectives guide decisions made by fund managers. The success of these funds largely depends on the skills of the fund’s managers.
The ability to diversify a portfolio helps investors stay secure, smart, and protected in their investment choices. Portfolio diversification helps meet short- and long-term investment goals and remain protected from volatility.