Whether you’re investing in stocks or real estate, you’re probably going to hear a lot about the importance of a diverse portfolio. Portfolio diversity is a critical way for you to protect your investments and improve the likelihood that your total investment earnings will grow.
This guide will teach you how to diversify your portfolio, no matter which kind of asset you’re investing in.
What Is Portfolio Diversification & Why Does It Matter?
Diversification is a practice in which you invest in different types of assets or securities. When you diversify your portfolio, you’re essentially just spreading your investments across a broad spectrum of assets and industries.
Diversifying your portfolio has two main advantages:
Your investments are better protected
There’s a greater likelihood that your portfolio will grow in value
Diversification matters because it spreads your capital across different investment types and markets. Not only does this safeguard your portfolio from sudden drops, it also increases your ability to benefit from a variety of sources.
What Goes Into A Diversified Portfolio?
A diversified portfolio is made up of several different investment types including stocks, bonds, real estate, REITs, or other asset types. The key is to spread holdings across various groups to ensure not all of your portfolio is dependent on the same investment.
Many investors follow the 60/40 rule, where 60 percent of an investment portfolio is made up of stocks and 40 percent is fixed-income investments. However, this is not a hard and fast requirement for a diversified portfolio. Ultimately, the right asset makeup depends on the investor.
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The main reason that investors aim to diversify their portfolios is to mitigate risk exposure. You might have heard the phrase, “Don’t put all your eggs in one basket.” That’s just another way of saying, “Don’t bank on one type of investment to create wealth.”
If you put all your eggs in one basket, then all your eggs will break if something happens to your basket. Similarly, if you invest in only one type of asset or industry, then you’re more at risk of your entire portfolio taking a loss. A recession, business closure, or market decline could tank your earnings.
Diversification is a smart way to reduce your exposure to a particular type of risk. Let’s assume, for instance, that you’ve only invested in stocks. If the stock market crashed, then you’d take a loss on all your investment earnings. But if you also invested in bonds and real estate, then those assets would still provide you with a cash flow despite your stock losses. You could counterbalance any losses that you take.
Diversification isn’t just about risk mitigation—it’s also an excellent way to promote investment growth.
When you spread out your investments across many different types of assets, there’s a greater chance that one of them may generate those lucrative returns that every investor hopes for.
Remember that the safest investment strategy is to hold long-term assets that will yield returns after five years or more. Long-term investments are better able to weather the inevitable drops that occur on the investment rollercoaster.
How to Diversify Your Investment Portfolio
Diversification is different for everyone. How you diversify your investment portfolio depends on your investment goals and your income.
First, you should be familiar with the different asset classes in which you can spread your investments:
Stocks: Shares of a corporation, which may provide you with regular dividends and interest. The value of an individual stock can increase significantly over time, but they’re also among the most volatile and risky investments.
Funds: These are baskets of securities that the investor can buy a share in. The investor doesn’t own the stocks that are included in the fund—only a portion of the fund’s indexed profits.
Bonds: Loans paid out by an investor to a corporation or government, which are usually paid back at predetermined intervals, with interest.
Commodities: Physical assets, like crude oil or gold.
Real Estate: It’s good to think about real estate as an investment—most properties tend to appreciate in value. Real estate can provide some of the most lucrative returns.
As you can see, there are lots of different ways you could diversify your investments.
Suppose you’re trying to use your investments for saving purposes (retirement, home financing, etc.). In that case, you’ll probably want to invest in a variety of exchange-traded funds, mutual funds, or fixed-income securities—any investment that generates reliable, long-term returns.
But if you’re trying to develop a passive income, you might consider investing in something that generates more immediate income, like a rental property.
You could also diversify within a single asset class. For example, if you were investing in stocks, you could buy shares in companies from different sectors—like technology and food. If the technology industry were to take a loss, you’d still own stock in another, more profitable sector.
Here are a few key tips on how to diversify your investment portfolio:
Break down future goals into short and long term.
Invest in ETFs and Mutual Funds
Invest in Index Funds and Fixed-Income Funds
Invest in Foreign Assets
Know When to Sell
Asset allocation is when you allocate a certain percentage for each of your investments. For example, you might decide that 30% of your investments will be in mutual funds, 40% in bonds, and 30% in retirement accounts.
Decide which assets you’re going to invest in and determine how much of your capital to allocate to each. Remember to keep your percentages as balanced as possible.
A robo-advisor can be a tremendously helpful resource. Most robo-advisors will automatically take your capital and invest in a variety of diversified assets. When your portfolio falls out of balance, the robs-advisor will automatically rebalance your portfolio for you.
If you have a higher amount of capital to invest ($10,000+), you might consider using an investment method called dollar-cost averaging. Here’s what this practice entails. You’ll determine how much you’re going to invest in an asset, and then you’ll divide it up into a series of recurrent purchases.
For example, let’s say you’re going to invest $10,000 in a mutual fund. Since you’re a long-term investor, you decide to invest this money over five years, at about $166.66 per month.
Why is dollar-cost averaging helpful? Because the market tends to act like a rollercoaster, with annual ups and downs. By spreading out your investment equally over a longer period, you’re more likely to have counterbalanced the highs and lows after you’ve invested the last dollar. It’s not an unusual strategy; a 401(k) retirement plan works in the same fashion.
Invest in ETFs and Mutual Funds
Exchange traded funds (ETFs) and mutual funds are the perfect assets for investors seeking diversification.
Both of these funds contain a basket of securities of which you can buy shares. Because they each contain various stocks (often hundreds or thousands of individual stocks), they’re much more diverse than a single stock.
Another great benefit of ETFs and mutual funds is that they’re diversified by asset class—you can find ETFs or mutual funds that hold stocks in different sectors and business sizes.
Try investing in at least five different ETFs or mutual funds, ensuring that each asset class is different. Try not to have more than 25% of your ETF/mutual fund capital in a single fund.
Invest in Index Funds and Fixed-Income Funds
Index funds and fixed-income funds can protect your portfolio from volatility. Index funds match a broad market index’s performance, and these indexes are well-diversified and tend to rise in value. Fixed-income funds (like a corporate or government bond) provide you with steady returns for a predetermined term.
Neither index funds nor mutual funds will generate huge gains, but they’ll provide you with steady and reliable gains over a long period.
Vary Investments by Size
Invest in both small companies and large companies. While larger companies tend to be safer investments, a small company could potentially generate larger returns. Investing in companies large and small is an excellent way to balance risk and reward.
Pro Tip: You can find ETFs and mutual funds that exclusively hold stocks for large companies, medium-sized companies, or small companies.
Invest in Foreign Assets
The United States has the world’s largest market capitalization, but we’re living in a global economy these days, and foreign markets are important. Consider investing in ETFs and Mutual funds that hold only foreign securities.
Changes in the American economy certainly create ripple effects that are felt around the world. Still, if some United States markets decline, you could benefit by owning shares in foreign markets that are thriving.
Consider bookmarking the “World News” page of an online news provider or business news website. These will keep you in the loop on what’s happening in foreign markets.
Know When to Sell
We’ve been talking about long-term investing, which requires a “buy and hold” strategy. It’s important not to overreact to short-term losses that your investments may incur. However, suppose it’s clear that a market has been permanently damaged by new technology, powerful new competitors, or lack of consumer interest. In that case, you might be better off selling your investments and reinvesting in a new type of asset.
Keep informed about what’s going on in the marketplace, whether it’s the stock market or real estate. Market knowledge will help you gauge whether or not your investment is likely to make a comeback.
Tips for Diversifying Your Portfolio
Here are a few important tips for diversifying your portfolio:
Don’t Over-Diversify: Diversification is not a bulletproof investment strategy, and it won’t provide 100% protection for your assets. Also, remember that you may suffer from low returns if you’re not well-invested in any of your assets. You could miss out on growth. For example, it might be more lucrative for you to invest $500 each in 10 companies than to invest $50 each in 100 companies.
Choose Your Broker Carefully: If you know you’re going to be investing in stocks or ETFs, be sure you select a broker that offers low trading costs or no trading costs. Online brokers usually offer commission-free trading for stocks and ETFs.
Pay Attention To Commissions: As you identify new investments, be sure to pay attention to the fees and commissions associated with trading and selling. If you work with a portfolio manager, always be aware of their fee structure as well.
Keep Building: When you reap the returns of your diversified portfolio, consider how to best reinvest. Many investors rely on dollar-cost averaging, a strategy that sets aside a certain portion of returns for future investments. No matter which method you choose, take advantage of your portfolio growth and keep looking for opportunities to diversify and invest.
How to Diversify Your Real Estate Portfolio
Real estate is one of the most lucrative asset classes, and it’s a great way for any investor to diversify their portfolio—even those who prioritize securities.
You can diversify your real estate portfolio in the same way you diversify your securities: you’ll invest in different asset classes. In other words, you’ll invest in different types of properties.
Residential rental properties, Vacation rentals, and fix-and-flip investments are real estate investments you can do for diversification. But you can create further diversification by investing in multifamily properties, commercial properties, and REITs.
Investing in Multifamily Properties
A multifamily property, also known as multi-dwelling units (MDU), is residential housing with two or more units under a single roof.
This is the least common type of residential building, and it’s compelling for investors because it can produce a larger cash flow than a single-family rental property. That means it carries less risk.
The benefits of investing in multifamily properties include:
Less Risk: For rental properties, the biggest risk is the loss of income, which typically happens through a vacancy. Since an MDU has more units, it can alleviate the total economic loss for vacancies that occur.
Cash Flow: An MDU can generate a cash flow that’s much higher than a single-family rental property, so long as the MDU can produce rent prices that create sufficient profit to cover the mortgage costs.
Investing in Commercial Properties
Commercial properties, like office buildings and shopping centers, are a natural progression for experienced real estate investors.
“Making the jump from single-family homes to learning how to invest in commercial real estate can be an incredibly lucrative career choice,” says Than Merrill, my colleague at FortuneBuilders and CT Homes. “However, commercial real estate investing is a different animal; the numbers on a single deal alone can trump even the most expensive single-family homes. Investing in commercial real estate will require a new set of skills, and some people will want to make the transition a little slower.”
The benefits of commercial properties include:
Less Competition: Commercial properties are a major undertaking for investors because they’re expensive and require complicated financial planning. But they’re also lucrative for the few investors who can handle the workload.
Cash Flow: Because commercial real estate leases are generally longer than residential rentals, investors have a unique advantage over traditional investors to earn relatively consistent and reliable income every month. Commercial real estate will typically earn a better return on investment than single-family homes, fetching between six and 12 percent, compared to residential properties that will earn between one and four percent.
Triple Net Lease: The general concept involves having tenants pay for the building’s taxes, property insurance, and maintenance costs, in addition to the monthly rent. Although there are many variations, the idea aims to have property owners pay no expenses on the property other than the mortgage.
It’s important to know that the commercial property market could be in flux. It’s possible that the COVID-19 pandemic could permanently increase the number of Americans working from home while reducing the demand for commercial properties. There could be some exciting opportunities for investors who are paying close attention to the market.
Investing in REITs
A real estate investment trust (REIT) is a company that owns or finances income that produces real estate.
They work similarly to stock investments by offering common shares to the public but are contingent on the state of the real estate market rather than on an exchange. In essence, REITs are part of a private and public equity stock in real estate companies that invest in properties, mortgages, and other real estate-related investments. They offer all types of regular income streams, diversification, and long-term capital appreciation.
“In addition to the passive income rental properties and rehabs that have become synonymous with today’s residential redevelopers, investors must solidify long-term yields with the help of an REIT portfolio,” says Merrill. “Nothing, at least that I am aware of, carries more promise for long-term dividend yields at the moment than real estate trusts.”
Unlike direct real estate investments, where local property markets influence values, REITs are continuously valued, which can be both good and bad for investors. That said, investing in REITs is a terrific option for investors looking to diversify their real estate investment portfolio.
Diversification is a practice in which you invest in different kinds of assets. Diversification can help you protect your investment portfolio from underperforming assets, and it can boost your chances of investment growth. There are many different methods on how to diversify your portfolio: allocating your assets, prioritizing “basket-style” investments, and investing in a variety of different asset classes. To diversify a real estate portfolio, invest in different properties, especially in commercial properties, multi-dwelling units, and REITs.
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