A Look at the Importance of Portfolio Diversification
Nowadays, there’s no shortage of investment advice available to anyone who seeks it out. Much of this advice revolves around investments: what you should invest in, how conservative you should be, and what new investments you should consider. One of the most essential pieces of advice is related to the diversification of an investment portfolio. So, what does diversification mean with regard to your investments? We’ll look at how to understand diversification and some suggestions for how you could implement this strategy into your own investment portfolio. Whether you’re saving for retirement or just putting money away for a rainy day, a diversified investment portfolio can prove incredibly useful.
What Does Diversification Mean?
The importance of diversifying your portfolio is likely the number-one piece of investment advice you’re likely to hear when you begin creating an investment plan. In simple terms, the diversification of your investments merely refers to spreading out your assets among a wide range of different types of investments. The strategy can help you in one significant way: It can minimize your risk. Since no one investment holds a majority of your assets, it’s less likely to harm you financially if one investment takes a significant downturn. While it won’t guarantee that you’ll experience better gains or safeguard you against any type of loss, it can help you to minimize risk in a big way.
Diversification is not limited to the types of investments you make (for example, stocks, bonds, etc.). You should also consider diversification within these types of investments, so putting all of the assets in your stock portfolio into just one or two stocks would be generally ill advised. By diversifying your portfolio, you can more easily manage your preferred level of risk, an important factor for anyone interested in investing. You want to be sure that your portfolio is at a level of risk that you’re comfortable with and that it will help you to get the most possible out of your assets. By doing so, you will be able to protect your assets from volatility, such as major drops in several areas at once.
Common Components of a Portfolio
In a well-diversified portfolio, you will likely find a variety of assets in four main categories. Most people invest in domestic stocks as the most aggressive portion of their diversified investment portfolio. Stocks offer the opportunity for greater growth in the long-term, but that opportunity also brings with it added risk. That risk is particularly high in the short-term, since stocks can and often do lose and gain value rather quickly. For a less risky component, you should add bonds to your portfolio lineup. Most bonds that you can invest in will be less volatile than your domestic stocks, and many have the added benefit of offering you a regular interest income. The added security can impact your gains, however, since bonds generally experience significantly lower yields than stocks over time. While there are some higher-yield bond options with proportionally higher risk, bonds are generally used to provide portfolios with a sort of cushion against the volatility of the stock market.
In addition to domestic stocks, you can diversify your portfolio with international stocks. These international stocks will likely perform differently than U.S. stocks, providing you with varied opportunities. With international stocks, you’ll likely find even greater potential for higher returns, as well as an increased level of risk. Short-term investments are another typical component of a diversified investment portfolio. These can include money market accounts and short-term CDs (certificate of deposits). If you are more concerned with principal and less with potential gains, then you might want to increase your short-term investments. Money market funds will offer you greater security and easier access to your funds than most other investment options, although they are not guaranteed by the FDIC. CDs are typically insured or guaranteed by the FDIC, but you will not have the level of liquidity that you might find with a money market fund.
These four options are not the only ones to consider for your investment portfolio. There are a few other types of assets you can add to your stocks, bonds, and CDs. Sector and real estate funds can be good additions to your portfolio, and experienced investors could try their hand at commodity-focused funds. If you find yourself short on time, then adding asset allocation funds to your portfolio could help.
Remember, diversifying of your portfolio is not a one-time undertaking. In order to obtain the greatest benefit from your assets, you need to reassess your portfolio and level of risk at regular intervals, making adjustments based on your changing needs.