How can you make more money when investing? And how do you protect your investments from market downturns and unexpected future events? The answer is diversification. If you’re looking to build your investment portfolio, diversifying is important.
A diversified portfolio can help protect your income and wealth during various stages of the economic cycle and provide good long-term returns.
Here are seven tips for diversifying your portfolio.
Spread your money across multiple asset classes
By investing in multiple asset classes, your overall returns will be less volatile because losses or low returns from one asset class are offset against gains or high returns from another. You’ll also be less exposed to one economic event, so if a company or sector you’re investing in doesn’t perform well, you won’t lose all of your money.
An investment portfolio with a 100% allocation to shares, for example, wouldn’t do well during an economic downturn. So it’s important to diversify across different asset classes, such as:
- international bonds
- international shares.
Diversify within an asset class
Even within asset classes it’s important to diversify, to provide further protection against unexpected events. For instance, you’ll want to consider investing in various types of bonds (fixed rate, floating rate, inflation-linked). These can help reduce your income risk, interest rate risk, and inflation risk. You can also invest in both corporate and government bonds.
When it comes to stocks, you should have about 15 different stocks in your portfolio for diversification, including blue chip, second-line, and speculative stocks. Together, these offer security, growth potential, and speculative fun to increase your return. This can help manage your portfolio risk and minimise the impact of one stock having too much influence on the portfolio.
As for property, if you’ve already invested in residential property, you should consider investing in commercial property for further diversification.
Invest in both high-risk and low-risk assets
You can also grow and protect your wealth by diversifying risk. High-risk or “growth” assets have higher returns, whereas low-risk or “defensive” assets have lower returns.
High-risk assets have more volatile returns over the short term, but the higher risk and volatility can be offset by investing in low-risk assets that have lower short-term volatility.
How much of your portfolio you allocate to high-risk and low-risk assets will depend on your:
- risk tolerance
- financial situation
- personal circumstances.
For example, if you’re near retirement age, you need more predictability in your portfolio because you have less time to recover lost capital. You can do this by increasing your allocation to fixed income to decrease the proportion in high-risk assets.
Choose different industry sectors
Different industry sectors perform better at different times, and some sectors are more volatile than others. This shows the importance of investing in multiple sectors within an asset class. Sectors of the Australian share market include:
- S&P / ASX 200
- consumer staples
- materials (including resources)
- consumer discretionary
- financial services
If you invest in stocks in various sectors, you’ll expose your portfolio to growth in different areas of the economy and it’ll be less vulnerable to a downturn in a specific industry. You can use a financial analysis tools to help you identify top stocks from different sectors to buy and sell.
Invest in different companies in the same sector
If you have a stock in the same sector, consider having one leading company (larger capital) and one emerging company (smaller capital). In the healthcare sector, you can invest in a hospital and in a pharmaceutical company. This’ll give you a good mix of companies across your portfolio. And if one company does poorly, you still get the benefit if another company does well.
You can also invest in the following types of companies in the same sector:
- fast-growing company
- slow-growing company
- turnaround company bouncing back from the grave
- old plodders that still manage to grow
- highly-geared company
- low-geared company
- big company
- small company.
Invest in both local and international markets
If you invest in the Australian market and in international markets, you’ll reduce your exposure to one market. Different markets peak at different times; for example, when the Aussie market is down, the US or Asian markets may be up.
You can invest in international markets directly or via an overseas share option in a managed fund, exchange-traded fund (ETF), or superannuation fund. Just keep in mind that when you invest some of your money overseas, changes in currency exchange rates can increase or decrease your returns.
Diversify within a managed fund, ETF or SMSF
If you have a managed fund or an ETF, focus on diversifying within the fund by employing the expertise of various investment fund managers to manage each of the different sectors within different asset classes.
Additionally, you can invest in different asset classes and different sectors through your self-managed super fund (SMSF). You can also achieve a diversified fixed income portfolio through your SMSF by holding different types of bonds with varying credit quality. Think carefully about what you invest in as they should be appropriate in terms of your risk tolerance and be in line with the fund’s main purpose of building savings for your retirement.
Diversifying for wealth and success
By diversifying your investment portfolio, you reduce the risk of being exposed to just one asset class, company, sector, or market. This in turn reduces the volatility of returns on your overall portfolio. And not only will having a diversified portfolio help you sleep better at night, it’ll also set you on the road to wealth and success.