In the financial world, having too much of your money in one asset is called “over-concentration.” It’s a problem because it leaves you exposed to risk. If the value of that single asset drops, so does your net worth. The good news is that there are ways to diversify your portfolio while still making smart investments and getting a return on your money that’s better than keeping it in a savings account or hoarding cash under your mattress. A diversified portfolio means you aren’t betting everything on one horse; instead, you have several different types of investments working together to improve your financial future.
What is a Diversified Portfolio?
A diversified portfolio is a mix of investments designed to reduce risk and increase returns. The more assets you have in your portfolio, the more likely you will make money and the less likely you will lose money. Diversifying your portfolio will depend on your personal situation, risk tolerance, time horizon, and goals. Having a diversified portfolio will help you manage the ups and downs of the stock market to make sure your money continues to grow. Like many things in life, the more things you have going for you, the better.
Why You Should Have a Diverse Portfolio
Typically, the greater the risk, the greater the potential gain. So, if you invest all of your money in very safe investments, your portfolio will grow slower than if you were to take more risk with your money by investing in more aggressive assets. When you have a diverse portfolio, you have the best chance of making money during economic and market cycles, including down market conditions when most people lose money. The more investments you have in your portfolio, the more likely you will experience a positive return during each market cycle.
In short, you need a diversified portfolio because:
- It helps you balance risk and reward.
- It spreads your money across different kinds of investments.
- It gives you a better chance of making a profit.
- It protects you if one or two of your investments tank.
How to Build a Diversified Portfolio
The first step to building a diversified portfolio is deciding how much of your money to invest in each asset. You want to strike a balance between not putting too much of your money into any one thing and not spreading yourself too thin. When building a diversified portfolio, it’s essential to remember that no single investment is guaranteed to pay off.
The best way to approach diversification is by first figuring out what you’re trying to achieve. Is the goal to earn higher returns for the same amount of risk? Or are you trying to lower the amount of risk in your portfolio? Once you know what you’re going for, you can start choosing your investments.
- Choose your asset classes: Generally, you’ll have between three and seven different asset classes when you’re building a portfolio.
- Make sure each asset class is represented: You can’t just throw a couple of stocks into a portfolio and suddenly consider it “diversified.”
- Balance risk and reward: You want to ensure you’re getting a healthy return on your investments without taking too much risk.
- Match your portfolio to your goals and risk tolerance: Your investment strategy will depend on whether you’re saving for retirement, paying off student loans, or funding a startup.
Fixed Income Investment
The best way to describe “fixed income” is that it’s a type of investment that pays you a consistent interest rate. Companies, governments, and other organizations use this investment to raise cash. There are many types of fixed-income investments, including bonds, Treasury bills, and money market funds.
- Bonds are one of the most common types of fixed-income investments. A bond is a loan typically issued by a company or government and paid back with interest over a set period. Bonds are a type of debt that gives you a predictable fixed payment because the issuer has to pay you back with interest.
- Treasury bills are another common type of fixed-income investment. Treasury bills are short-term loans issued by the government, and you are guaranteed to get your money back with interest. Treasury bills with a maturity of less than one year are sometimes called T-bills.
- Money market funds are pools of money contributed by many investors. Money market funds are very safe, but they also pay a lower interest rate than Treasury bills or other fixed-income investments. The fund manager invests the money in low-risk investments, such as short-term Treasury bills or different types of fixed-income securities.
An equity investment is a type of investment in which you own a portion of the company you’re investing in. For example, if you buy stock in Tesla, you own a piece of the company. If the company’s value goes up, your investment increases in value. If the company’s value goes down, so does your investment.
Equity investments are riskier than fixed-income investments because they rely on the company doing well and on you being able to sell your shares at a profit. The stock market is also less predictable than the fixed income market.
- If you want to invest in stocks, you can choose from many different equity investments, including funds that invest in various stocks. With funds, you can spread your money out among many different companies, which reduces the risk of losing all of your money if one company goes bankrupt.
- Keep in mind that equity funds are not guaranteed, so you could lose all of your money. Equity funds are also subject to market risk, which means that you could lose money in a down market.
Alternative investments, such as real estate or commodities, are types of investments that are not traded in a public market. They are usually riskier than stocks and bonds, but they can also have a higher expected return.
Real estate, for example, is often funded with a combination of equity and debt. You could own a portion of a building as an equity investment, while a bank or mortgage company could own the rest as a debt investment.
Commodities are oil, natural gas, gold, silver, copper, art, and watches. Before you make any investments in commodities, you need to do your research and discover the best way to approach this to not only diversify your portfolio correctly but also understand what you are investing in and how to build a collection if this is something you are planning on doing.
For example, if you are investing in art, a curator can advise you on the best type of art for you, and how to build a collection of art from the same, or similar artists for maximum returns. The same goes for watches. A horologist is an expert in watches. This knowledge, investment experience, and expertise can allow consultants like Eric Brahms to guide you in making suitable investments in timepieces.
Keep in mind that alternative investments are riskier than stocks and bonds, and they don’t have the same level of liquidity. This means you can’t get your money out as quickly as possible, which can be a problem if you need it before your investment matures.
The Bottom Line
The bottom line is that when you diversify your portfolio, you decrease your risk. If one or two of your investments go bad, you’re protected because you have other assets in your portfolio that can help make up the difference.
Depending on your goals and risk tolerance, you’ll want to mix and match different investments in your portfolio. An excellent place to start is by opening an online brokerage account to begin investing in stocks, bonds, and other types of assets.