Why should I diversify my portfolio? Doesn't it make sense for me to put it all on black and invest in one asset that yields the highest returns?” In a utopian world that may work, but the volatility of markets has taught us otherwise. The principle behind portfolio diversification is the understanding that different asset classes exhibit varying risk and return potential. Stocks, bonds, real estate, commodities, and cash equivalents each possess unique characteristics. A combination of these assets in a balanced manner can protect your assets from market fluctuations.
A well-diversified portfolio boasts of the following components:
Asset Allocation: Distributing your investments across different asset classes is known as asset allocation. It is a fruitful practice to balance your investment across stocks, bonds, real estate, and cash equivalents in a way that aligns with your risk tolerance and investment goals.
Geographic Diversification: Economic conditions, political events, and regulatory frameworks vary globally. Think about diversifying your portfolio geographically to protect your assets against localized risks.
Industry and Sector Diversification: When investing in the stock market, a spread of investment across various industries is a great practice to reduce your exposure to specific industry risks.
Individual Securities Diversification: If you decide to invest in individual stocks, spreading your investments across a range of companies can reduce the impact of adverse events affecting a single company.
How do I go about this?
Easy.
You can achieve this by investing in index funds, exchange-traded funds (ETFs), or by selecting individual securities with diverse characteristics.
Time Diversification: Continuous periodic investment out trumps putting your money in the market all at once. Invest at regular intervals (regardless of market conditions) to cushion the impact of short-term market fluctuations.
The following benefits may convince you to diversify your portfolio today!
Risk Reduction: Allocating your assets across different securities can curb the impact of any singular investment’s poor performance on the entire portfolio.
Consistent Returns: Some investments may experience spikes or downturns, and others may perform great, balancing out the overall performance of the portfolio. Hence, it is said that diversification leads to more stable and consistent returns.
Improved Risk-Adjusted Returns: Compared to a non-diversified portfolio, a diversified one delivers a higher return for a given level of risk. This is due to the reduction in the overall volatility of the portfolio while still providing growth for your assets.
Protection against Volatility: When the market is in a downturn, certain assets may act as safe have. provide a cushion to the overall portfolio.
If you are contemplating how you can diversify your portfolio, keep the following pointers in mind:
Investment Goals and Risk Tolerance: Create well-defined investment goals and set a limit for risk tolerance before you begin diversifying. This will provide direction to your investments and create a well-balanced portfolio.
Asset Correlation: Look for assets that have low correlations with each other. Having a portfolio that includes independently moving assets can cushion the impact of volatile markets.
Number of Holdings: But don't go overboard with the diversification. Avoid it at all costs, as it can dilute gains and increase complexity. A common guideline is to have 10-20 holdings in your portfolio.
Asset Allocation: Allocate your assets on the basis of your risk tolerance, investment goals, and time horizon.
Rebalancing: Review your portfolio regularly in order to rebalance it whenever required. Sell your assets that have become overweight and buy assets that are underweighted to bring your portfolio back in line with your target allocation.
Research and Due Diligence: Research each investment like your life depends on it before adding it to your portfolio. Assess its fundamentals, risks, and historical performance. This knowledge will help you make smart decisions regarding your investments.
Costs and Fees: Don't forget about the costs associated with each investment like management fees, expense ratios, and transaction costs. High fees can chip away your returns over time.
To make a long story short, portfolio diversification will 100% help you in curtailing risks posed by the volatile market. A balanced spread of investments across different asset classes, industries, and geographic regions will help your portfolio give you fairly consistent returns. If you are still in doubt, book a free 15-minute consultation with JJ Tax. Our team of experts can look over your portfolio and advise you on how you can make your money work for you in the most efficient way possible.
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