The investing journey is full of risks and bumps. And diversifying the investment is one of the ways to reduce the risks. Diversification is an important concept that means investing in many assets. Time and correlation are the two key elements to diversify an investment portfolio. Make sure you know when to use the money. Also, spread your investments in different areas with negative or low correlation. In general, there are two ways to diversify. They are:
- We can invest in multiple asset classes.
- Within each asset class, we can invest in many assets.
Some ways to diversify the investment portfolio are:
Use asset allocation funds
Asset allocation funds are a predetermined mix of stocks and bonds. For example, a 60/40 fund means it maintains 60 percent stocks to 40 percent bonds. Also, target-date funds can be a proper way. In this approach, you can choose a period. Then, the fund managers diversify and make necessary changes. However, using target-date funds has a drawback. It is usually developed for average investors. So, it does not work to fulfill your individual preferences.
Invest in negatively correlated assets or asset classes
When assets A and B are positively correlated, their returns move together in the same direction. And, when they are negatively correlated, their returns move in opposite directions. You can compensate a loss in one asset by a profit in the second asset to a certain extent. Hence, we get more diversification benefits when the assets are negatively correlated. The best we can do is diversify our investments across multiple assets that are least positively correlated.
Invest in a mix of mutual funds or Exchange Traded Funds (ETFs)
Investing in a mix of mutual funds or ETFs is a satisfactory way to diversify your investment portfolio. It results in a more tailored investment portfolio. You can check your top 20 holdings and determine your portfolio diversification. If you are avoiding a lot of overlaps, then it ensures a truly diversified portfolio.
Do not invest in too many asset classes
One common misconception of investing is “the more stocks, the merrier”. But we often get no additional diversification benefits by having beyond 30 stocks in our equity portfolio. Thus, diversification is not about involving as many assets as possible. It is about reducing the correlation between assets in our portfolio.
Vary company size and type
In simple ways, you can diversify your portfolio at two levels. They are:
- Between asset categories, such as a mix of stocks, bonds, commodities, real estate, and cash.
- Within asset categories such as investing in companies and bonds of different types and sizes.
Having an international exposure is another way of diversifying the investment portfolio. Investors should not be biased towards domestic assets only. You can benefit from growth overseas if you are investing abroad. The U.S. stock market is about 50 percent of total market capitalization. So, the U.S. especially plays a significant role in the growth rate of international investments.