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- In general, the more varied and diverse your investments, the better they’re able to help you mitigate losses.
- Identify what type of investor you are.
- Manage risks and rewards.
- If you seek help, know what you’re getting into.
The short answer is that the better you spread your investments across different assets, the less likely they are all to suffer a loss. In other words: Your overall losses are likely to be less severe.
A diversified portfolio is kind of like a nutritious diet…
To stay strong, your body needs a variety of nutrients, from proteins to vegetables and fruits to carbohydrates. And within each of these food groups, different foods offer different vitamins. Carrots are rich in vitamin A, while broccoli is a good source of fiber, protein and iron. The more varied your diet, the more nutrients you’ll consume. A similar concept applies to investments. For a long-term investment strategy, not only can it make sense to spread your investments across different asset classes such as stocks, bonds, etc., but you can also diversify within each class as well as across countries, currencies and time.
However, diversification isn’t a panacea or a guaranteed hedge. Much like a balanced diet won’t protect you from ever getting sick (we all get sick from time to time), a diversified portfolio doesn’t mean your investments will never fall, or even fall drastically – diversification is simply a strategy that can help you avoid losses that might otherwise be severe, and has the potential to reduce the volatility of your returns.
What does a diversified portfolio look like?
The more diverse and diversified your investments are, the better they can help you cushion losses.
When it comes to where to invest your money, you are spoiled for choice. In addition to stocks and bonds, there are money market funds, real estate, commodities, private equities, and so on. You can also invest your money in different companies, industries, regions and currencies within each asset class.
With a diversified portfolio, the broader the range of asset classes and funds, the better it is at absorbing losses. Markets tend to move in cycles, and different markets may rise or fall at different times. In theory, a diversified portfolio can support your investments so that when some markets take a hit in a year, other parts of your portfolio can continue to grow.
So what kind of mix is right for you? The answer depends on who you are and what you want to achieve with your investments. Depending on your financial needs, personality and timing, you may want to put more money into a particular asset class or sector.
What kind of investor am I?
The more you get to know yourself, the better investor you’ll be.
Before you start diversifying your portfolio, ask yourself the following questions:
- What’re the main reasons you want to invest? Maybe you’re trying to save money for an emergency. Maybe you’re trying to pay off credit card debt or a student loan. Maybe you want to contribute to a retirement fund. For many of us, the answer probably encompasses all of the above. Whatever your goals are, knowing them in advance and prioritizing them will help you figure out what a “diversified portfolio” looks like for you.
- How risk tolerant are you? A common dynamic in investing is that you need to take greater risks to achieve greater gains. This may mean putting a higher percentage of your investments in stocks than in bonds. Ultimately, any investment involves some risk, and for most of us, the idea of losing money can be very stressful. Ideally, a diversified portfolio will help you mitigate risk while getting the best possible returns from that portfolio. But to know how much risk you can take in your portfolio, it’s helpful to know how well you can handle stress, both financially and emotionally.
- What’s your investment timeline? One piece of advice you may hear from investors is that the earlier you start saving, the better. In theory, the longer you leave your investment untouched, the greater its growth potential. However, your timing may vary depending on your goal. For example, if you’ve an immediate goal, such as an emergency fund, you should only take a year to save. If you want to save for retirement, your time frame may be 30 years or more. Knowing your time frame will help you determine how fast your investment needs to grow and how much risk you’re willing to take along the way.
What are some examples of investment classes or categories?
Here are three examples of important asset classes:
- Stocks can be one of the most volatile asset classes. In other words: One year a stock’s returns can be very high, followed by a sharp loss the next year. Stock investments can have great potential for high returns, but this is generally true for investors who’re willing to go through multiple boom and bust cycles, which can take a long time.
- Bonds are generally considered a safer source of returns than stocks, but their returns are also lower on average. Consider them a lower-risk, lower-return category.
- Cash and cash equivalents include your typical savings account as well as Treasury bills and money market accounts. They’re often considered the safest investments, but they’re also known to have some of the lowest returns of the major asset categories over time. Remember, each of these categories can be made up of a range of companies, industries and geographic regions. And there are a whole host of categories beyond these three. Real estate, commodities (like gold, oil, water) … the list goes on. It’s important to note that each asset category and sub-category can have a different return (ROI) depending on the year.