Why Diversification Matters for Your Portfolio
Sorry, but you’re not Nostradamus. It’s claimed that the 16th century sage predicted world events that occurred centuries later. There’s no such luck in the markets. So many factors affect the price of stocks, bonds and alternative assets. Individual company events, industry trends, world occurrences, government actions, or just plain luck play roles. These factors change in real-time, affecting equity, bond and asset values.
Few predict these changes with any degree of accuracy or regularity. That’s where diversification comes in. It’s a powerful weapon against the risks caused by, well, everything.
Diversification is when you invest in many securities. Spreading out your investment across stocks, bonds and other investments mitigates risks in specific businesses, locations or industries.
There are three broad areas in which you might diversify. Savvy investors use them all to reduce risk.
Equity Diversification
Don’t plunge your life savings into a hot tech stock. That links your entire financial fortune to a single stock’s performance. The rewards may be huge. But so is the risk. Kind of like going to Vegas and betting it all on black.
Diversification is the more sensible route. You spread that money out across many equities. Maybe one of them is that hot tech stock. But if the tech stock fails, it doesn’t sink your whole portfolio.
There’s no magic number of stocks to own. In the U.S., consider 20 to 30 different equities. Diversifying beyond that doesn’t hurt, either. Make sure assets are uncorrelated or inverse for the best results. You don’t want to invest everything in the same industry or industries related to a single sector. You may also pinpoint industries that do well when other stocks in your portfolio don’t.
If it’s a bad year for oil and gas, you might face serious risk if those are the only equities you hold. But if you invest in industries that go up when oil goes down, you mitigate your risk exposure in oil and gas.
Financial Instrument Diversification
It’s also worth diversifying outside of equities. That means investing in the bond markets. Bonds and stocks can sometimes be inverses of each other. Potentially when one goes up, the other goes down.
A balance of stocks and bonds can protect against macroeconomic shocks. If the stock market crashes, your entire portfolio doesn’t get wiped out. If a nation defaults on its bonds, you don’t suffer as much with a healthy equity / bond mix.
You’re using the same strategy as you did with stocks, except on a macro level. Instead of picking uncorrelated or inverse businesses, you’re picking uncorrelated or inverse macroeconomic factors.
Real Estate and Asset Diversification
Beyond stocks and bonds, there are alternative assets you can invest in. They offer one more way to diversify your portfolio. Real estate investments are primary alternative assets that investors prize. Real estate investments offer cash flow, since properties generate rent. And it’s a hard asset that can hedge against inflation and can potentially offer tax benefits.
But in the past there’s been one problem. You needed deep pockets to invest. Many commercial deals required at least $50,000 to $100,000 to start. And you needed the hustle and connections to access good deal flow.
Now, real estate crowdfunding gives accredited investors access to quality deals for as little as $5,000. By pooling money, investors buy into large deals. But, they can spread their capital across more properties. And, investors who couldn’t meet previous minimums now have access to real estate investments.
Diversification comes in several forms. Leverage them all to build a stronger, more balanced portfolio this year.