Why should my Portfolio be Diversified?
When you build a diversified portfolio, you are managing the risk of your investments. A diversified portfolio can take bigger risks by mixing in safer investments.
Diversification also protects against events that hurt a single stock, sector, or region. Major storms, conflicts, and political turmoil are some examples of unpredictable events.
In this article, we'll discuss how to diversify your portfolio. We also will discuss maintaining diversification as market conditions change.
How Can I Diversify my Investment Portfolio?
The key to diversifying your portfolio is assessing risk. By assessing risk, you can grow your portfolio while still holding on to safer assets.
Qualitative Risk per Stock
For new investors, the main way to measure the risk of a stock is through a stock's beta. Beta measures how much a stock changes relative to the change of the market. A higher beta means a minute fall in the overall market will give you a large fall in your stock.
A beta of one means that the stock will rise and fall in the same way as the overall market. An ETF like SPY has a beta of 1.0 because it is a basket of S&P 500 stocks.
When your stocks have a range of betas, you can minimize your exposure to market corrections.
Diversify your portfolio by sector. Each sector could have unforeseeable risks and opportunities. In general, the following examples are risks associated with some stock sectors.
Technology - High risk, high reward. Tech stocks tend to have high betas. Have tech stocks to add growth to your portfolio.
Manufacturing - Medium risk, medium reward. Manufacturing stocks tend to be consistent businesses.
Energy - High Risk, medium reward. Energy includes oil and gas, nuclear, and renewable energies. But as of 2022, it's dominated by oil and gas. Oil and gas are intertwined with politics and regional stability. Expect more volatility from this sector.
Utilities - Low Risk, low reward. Utilities provide electricity, gas, and water to commercial and residential real estate. Utilities historical have low betas. Hence, utilities have lower growth but historically higher dividends.
Its pointless to diversify your portfolio if you put 50% of your assets in only one stock. Conversely, putting a miniscule amount in one position is just as pointless. Keep your portfolio equal weighted to keep your portfolio diversified.
Beyond your stock portfolio, having alternative investments are good to diversify your wealth. Consider investing in real estate, collectibles or other assets. Note that these assets come with risks.
Invest in Bonds
Don't ever hold cash. If you need a safer investment to diversify your risk, use bonds or bond ETFs to diversify your positions.
Besides diversifying sectors and risk, it's important to diversify by regions. Even in this global economy, different regions can get hit by war or political instability. Try global ETFs like Global X FTSE Southeast Asia ETF (ASEA) or Invesco India ETF (PIN). Note that these assets are traded on stock exchanges as ADRs. To investing in global stocks, you may need to pay ADR fees.
Maintaining a Diversified Portfolio
Rebalance your portfolio periodically
Set a goal quarterly or annually to rebalance your portfolio to an equal weighting. The best way a portfolio goes out of balance is when one of your stocks jumps in value. Rebalancing your portfolio back to equal weighting let's you sell high and buy low. You can sell a portion of your high value stocks while reinvesting in stocks at lower prices.
Understand factors that impact the financial markets
The stock market will have periods of growth and periods of contraction. Having a diverse portfolio to withstand these moves will keep your capital in tact.
Too much speculation has been the ultimate driver in the last two market crashes. The 2000 crash was in technology while the 2008 crash was due to real estate. Too much speculation can occur in any sector, so it's important to diversify into multiple sectors.
Avoid jumping too fast into a sector because its "hot". Going "all in" on a "hot" stock can destroy your diversification and ultimately your risk-management.
The Bottom Line
Portfolio diversification is key to wealth building. Diversify your stock portfolio by risk, sector, and regions. This helps you avoid unforeseen impacts that drive down certain allocations.
Part of a Series for Beginner Investors