Veteran investors work to avoid money mistakes and to reduce risk by diversifying their portfolios among different types of investments. Diversification is something the best investment apps can help you with by making the task simple and quick to do. In this article, we'll share 13 smart ways to diversify your portfolio to help you reach your money goals.
What is diversification?
Diversification is the process of investing your money into different types of investments with the goal of reducing risk. You might have heard the saying, "Don't put all of your eggs in one basket." This is the idea behind diversification.
When thinking about how to invest money, you need to balance the potential for growth versus potential risk. With diversification, if one of your investments fails or is losing money, you might have other investments that are performing like a rocket ship or producing returns closer to their historic averages. These other returns could minimize the financial damage from an investment that is going down.
When there the economy is in a downturn or when the stock market is volatile, a diversified portfolio might perform better than one that is concentrated in one asset class. For example, if there is a bear market in stocks (when an asset class falls more than 20% over a period of time with widespread pessimism), bonds and alternative investments might stay the same or even go up. But always remember that past performance is not an indicator of future performance and there is always a risk of losing money when you invest.
For all these reasons, many people consider it a smart investment strategy to spread their money around. But how do you go about achieving diversification in your investment portfolio? Here are 13 different ideas.
13 smart ways to diversify your portfolio
1. Choose both short-term and long-term investments
Short-term assets are designed to be highly liquid and may not provide a high rate of return. Typically, they focus on the preservation of your money over seeking a higher return. Examples include savings accounts, money market accounts, certificates of deposit, and Treasury bills. The best savings accounts will at least earn you some interest on your cash.
When you add long-term investments to your portfolio, you take on more risk for a potentially higher rate of return. These investments tend to have more swings in their value.
To diversify, you’d want to have a mixture of both short-term and long-term investments, and this might also help you with a variety of short-term and long-term goals.
2. Buy index funds, mutual funds, or ETFs
Index funds, mutual funds, and exchange-traded funds make it easier to invest in multiple companies at once with a small amount of money.
- An index fund owns all the investments within a particular index, like the S&P 500, which is the largest 500 companies in the U.S.
- A mutual fund has a fund manager that picks investments that match its focus, like small-cap growth
- An ETF is similar to a mutual fund, but it can be bought and sold throughout the day like a stock
Even if one of these types of investments is focused on a small niche in the market, it is still diversified among many companies within that niche. When putting money in one of these investment vehicles, you'll automatically be diversified because you own a fraction of each of its investments.
3. Invest in a target-date fund
Target-date funds are a collection of investments that get more conservative as they get closer to their maturity date. These funds are designed to make it easier for beginner investors to get started. Rather than be overwhelmed by trying to pick individual investments, you can simply pick a target-date fund that matches the date you want to retire. The fund will choose a mix of different stocks and bonds on your behalf, then change the mix over time.
Say you were born in 1985 and want to retire at the age of 65. You would select a target-date fund with the date of 2050. It will start out weighted more heavily in stocks or stock mutual funds. As it gets closer to 2050, it will own more bonds and other fixed-income investments.
3. Invest in an asset allocation fund
Many mutual funds focus on a specific asset type. An asset allocation fund instead focuses on a diversified investment portfolio that includes multiple asset classes. The biggest advantage of an asset allocation fund is that certain asset classes will not dominate your portfolio. The investments have a target weighting (e.g., 60% stocks and 40% bonds). If the weighting gets out of balance due to market performance, it will automatically sell some investments and buy different assets to get back to the target portfolio.
One of the most common forms of asset allocation funds is known as balanced funds. Balanced funds own a mix of stocks and bonds and rebalance periodically to maintain the desired balance in the portfolio. Target-date funds are also considered asset allocation funds.
4. Add some individual stocks
By adding individual stocks to your portfolio, you could diversify your investments in a targeted fashion. These single stock purchases might take advantage of your expertise, current trends in the economy, or highlight your interests. For example, if you work in technology, you might notice that certain companies are poised for growth based on consumer or business adoption of their platform.
Just be careful not to trade on insider information, otherwise, you could be breaking the law. Insider information is material information that is not public and could substantially impact an investor's decision to buy or sell a stock.
5. Buy bonds
When interest rates decline, existing bonds increase in value. For example, an existing bond from Company ABC paying 4% interest is worth more than a new bond from Company ABC paying 2% because it produces a higher interest payment.
Bonds tend to move differently in value than stocks, so they might be able to temper your losses when the stock market declines. Therefore, adding individual bonds or buying into a bond fund could diversify your stock portfolio. Bonds come in many flavors, such as government bonds, corporate bonds, junk bonds, and international bonds.
6. Choose investments with varying levels of risk
Layering risk could increase your portfolio diversification. This is achieved by adding a mix of low-, medium-, and high-risk investments. You could do this throughout your portfolio in both stocks and bonds.
Bonds have investment grades that classify their risk profile. U.S. Treasury bills and bonds typically have the lowest default risk. Default risk is the potential that you won't be repaid. Municipal and corporate bonds can vary based on city and corporate finances. The highest risk bonds tend to be from foreign countries and corporate junk bonds. Junk bonds have high yields, but they have a higher risk of default.
7. Invest in different types of companies
Although you may have a personal interest in one industry, it’s smart for diversification if you invest in different sectors. As the economy goes through its cycle, different industries may perform better or worse. By having a piece of many industries, you might have a greater chance of one of your investments increasing in value.
For people who receive stock compensation, it is important that your other investments are diversified away from company stock. This reduces your concentration risk and enables you to participate in the performance of other companies that might be growing.
8. Invest in different size companies
Different size companies offer a variety of benefits to your portfolio. Larger companies tend to have lower risk, and some offer regular income through quarterly dividends. By comparison, smaller startups usually focus their profits on growing the company. Emerging markets are international companies that may be smaller and often are based in third-world countries. These are called large-cap, small-cap, and emerging market investments, respectively.
Investments in smaller companies and emerging sectors tend to carry more risk with a potential for higher returns. Adding a mutual fund or ETF that focuses on these companies or geographies could help diversify your portfolio.
9. Invest in international companies
Adding international exposure to your portfolio could smooth out your portfolio. Although the U.S. economy is one of the world's largest, focusing all your money on U.S. stocks and investments could mean you miss out on opportunities around the globe.
You could invest in a single mutual fund or ETF to add international companies or bonds to your portfolio, or you could select multiple investments that target certain countries or regions. For example, China and India have more than 1 billion citizens each, and Europe is home to many of the brand names we know and love in the U.S.
10. Rebalance regularly
Building a diversified portfolio requires occasional maintenance through a process called rebalancing. Although you set your allocation when you first create your portfolio, the performance of each investment can throw your allocation off balance.
Rebalancing is the process of selling investments that have grown and buying more that have declined in value. This gets your portfolio back to the mix you originally intended. Many investors choose to rebalance once a year on a date that's easy to remember (like your birthday or anniversary).
Alternatively, some investors choose to rebalance based on their portfolio's composition instead of a set date. They may rebalance whenever one holding deviates more than 5% from their ideal allocation. The best robo-advisors may automatically rebalance for you if you select that option.
11. Invest in real estate
Real estate investing is a popular diversification strategy when it comes to portfolio management. One way to get involved in real estate investing is through owning individual rental properties. For a more passive approach, you could invest in real estate through REIT stocks, mutual funds, ETFs, or real estate crowdfunding like DiversyFund and Crowdstreet. Fintech real estate apps make it easy to invest and you can open an account with a relatively small amount of money.
12. Invest in alternative assets
Alternative assets offer a variety of investment options that can diversify your portfolio. These assets are often non-correlated to the stock and bond markets, which means their values are not tied to the market performance of stocks and bonds.
Investors have many choices when it comes to alternative assets, including real estate, collectibles, private equity, and coins. These investments might not be as liquid as stocks and bonds, so investing in alternative assets should be viewed as a longer-term investment choice.
13. Take advantage of dollar-cost averaging
Dollar-cost averaging makes it easy to diversify. Whether it is through your company retirement plan, personal IRAs, or your brokerage account, it pays to dollar-cost average. Dollar-cost averaging is when you invest the same amount on a regular basis over time. You'll automatically buy less when prices are high and more when the price goes down. For these investors, market volatility increases the chance of buying more when prices are lower.
When setting up your dollar-cost averaging strategy, diversify the investments your contributions will go into. Then, you'll automatically buy more of each investment on the interval that you've set up. If your company provides a matching contribution to your retirement accounts, you'll buy even more.
How much money should I put in stocks?
You do not need to have a lot of money to start investing in stocks. Many of the newest investment platforms allow you to open an account with a zero balance and purchase fractional shares of stocks in small amounts. The amount of money you invest in stocks might vary based on your personal finance situation, goals, risk tolerance, and time horizon.
What is a good portfolio mix?
A good portfolio mix depends on your financial goals and risk tolerance. Many portfolios include a mix of stocks, bonds, money markets, and alternative investments. Beyond investing in these asset classes, investors often include both domestic and international stocks and bonds in their portfolios.
If you're having trouble selecting an appropriate portfolio mix, investing in a total stock index or a target-date fund might provide immediate diversification across a range of investments until you feel comfortable selecting your own. If you have more in-depth questions about investing, you might consider speaking with a financial advisor.
What are the dangers of over diversifying your portfolio?
As with most things in life, it is possible to have too much of a good thing. If you diversify too much, you could stunt your returns, increase transaction costs, and pay too much in taxes. Buying too many investments could also increase your concentration risk because some of the holdings may actually invest in the same stocks, bonds, or other investments.
Additionally, by having so many investments to keep track of, you could overcomplicate your finances and get overwhelmed. When this happens, investors tend to become frustrated and either stop investing or ignore their portfolios.
Diversification is an investment strategy that could help reduce the risk in your portfolio. Some of the strategies we’ve listed above are quick and easy to implement, whereas others may take a bit more homework to decide whether they're right for you. As your portfolio grows, you might want to pursue one or more of these diversification strategies.
For investors in taxable brokerage accounts, consult with your tax advisor before implementing a diversification strategy to ensure you don't end up with a large tax bill.