The importance of diversification for your investment portfolio
In addition to choosing the right assets to invest in, investors must also spread their risk to maintain healthy returns over the long term. An investment portfolio that comprises various types of investments that have little correlation with each other can create greater stability in times of economic uncertainty and market volatility.
Diversification is an important risk management strategy that involves investing in different types of assets, industries, and regions to reduce exposure to one specific type of risk, resulting in a more balanced and resilient portfolio that can better weather various fluctuations.
To mitigate the risk of returns being eroded, this article will explore the concept of diversification in more detail and set out some strategies that can increase your chances of building long-term wealth.
Why is diversification important?
There are various risks that can impact the performance of an investment portfolio. To achieve effective diversification, investors should take into account the following types of risks:
- Industry or sector-specific risk: Investment in one type of industry or sector only will increase your exposure to the specific risks associated with that industry or sector, making your portfolio more vulnerable to economic downturns or fluctuations in that particular market.
- Geographical risk: Political or economic instability in various regions can increase the risks associated with investing in companies that are based in one particular part of the world.
- Unsystematic risk: also known as idiosyncratic risk, this refers to risks that are specific to a particular company, asset, or investment rather than the wider market. Examples include management and operational inefficiencies, vulnerable business models, staff strikes, and regulatory challenges.
- Liquidity risk: Holding investments that cannot easily be converted to cash, or are illiquid, will increase this type of risk. This can cause financial difficulties in situations that require the need for immediate access to cash.
Experienced financial advisors like The Kelley Financial Group can help you create a tailored investment strategy that mitigates these risks and is designed to meet your unique financial goals.
Building a diversified portfolio
Consider the following components to achieve the goal of a diversified investment portfolio:
- Domestic stocks: Stocks usually comprise the main portion of an investment portfolio as they offer the opportunity for greater returns in the long term. While there is an inherent risk involved in investing in stocks, this risk can be reduced by diversifying your investments across different industries, creating a portfolio that can better withstand market fluctuations.
- Bonds: These fixed-income instruments tend to be a less unpredictable investment choice compared to stocks. This means they can act as a buffer against the volatility of the stock market. Government bonds such as S. Treasury bills can offer a more stable source of income through regular interest payments, providing investors with some financial safety during times when stocks are performing badly. While bonds generally offer lower returns compared to stocks, investors may also invest in high-yield bonds which also carry higher risk but can provide a potentially higher yield.
- Money market funds: Money market funds are types of mutual funds that invest in low-risk, short-term securities, which offer a highly liquid, stable, and reliable source of income through interest payments. As they provide investors with quick access to their funds they reduce liquidity risk, helping to balance their overall portfolio. The added safety of money market funds, compared to other investments does, however, mean that they offer lower returns than stocks and bonds making them a more conservative investment choice that can help provide a cushion against market volatility and economic instability.
- International stocks: Investing in stocks of other countries offer investors the potential for higher returns while helping them diversify their portfolios. International stocks have a lower correlation to domestic stocks and allow geographical risk to spread, providing protection against factors such as region-based political or economic instability.
- Commodities: Commodities, such as gold, oil, or agricultural products tend to have a low correlation with traditional financial assets like stocks and bonds, making them a valuable diversification strategy to reduce portfolio risk. When the value of stocks or bonds falls, commodities often hold or increase in value, providing investors with a counterbalance. They can also act as a hedge against inflation, as their prices often rise during times of high inflation. Investment in commodity-focused funds is a common way for investors to access this market.
- Real estate: Due to its low correlation with the stock market, real estate can play an important role in helping investors diversify their portfolios. By adding real estate investments such as physical property or real estate investment trusts (REITs) to an investment portfolio, losses that may be experienced in other asset classes may be offset, providing a level of protection against various risks.
- Precious metals: Precious metals like silver and gold are considered to be safe-haven investments due to their historical ability to retain value during times of economic downturn and market volatility. Precious metals can also provide a good hedge against inflation for investors as their intrinsic value tends to rise with increases in price, making them a reliable store of value during inflationary periods and when other assets face depreciation. In addition to these factors, the demand for precious metals often surges during turbulent economic times, helping to consolidate their reputation as safe-haven investments as well as attractive assets for building long-term wealth.
- Cryptocurrency: While this form of digital asset is known to be highly volatile, it is also considered to be an alternative asset class that can offer significant diversification benefits to investors. Cryptocurrency has a low correlation with traditional financial markets as its price movements are often unrelated to those of stocks and bonds. In addition, their decentralized nature means they operate independently of central banks and governments giving them an extra layer of protection against economic or regulatory risks. Some cryptocurrencies like Bitcoin also have a limited supply creating scarcity, and helping to protect against inflation.
Building a diversified portfolio can help to mitigate many of the risks associated with investing. However, allocating and maintaining this diversification can require significant time investment and an in-depth understanding of various asset classes and industries. As your portfolio grows it is advisable to consider professional portfolio management to ensure your investments continue working to your advantage.
