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What You Need to Know to Build a Diversified Investment Portfolio

What You Need to Know to Build a Diversified Investment Portfolio

If you’re making your first foray into the world of investing, then you should prepare to be told repeatedly not to put all of your eggs in one basket. In investing terms, this means diversifying your portfolio, rather than putting all of your money into just one or two investment vehicles. According to most financial experts, diversification is the foundation of any successful investment strategy, which is why this particular piece of advice is given so often. But what exactly does a diversified portfolio look like? And how do you build one? Read on to find out.

What is diversification, and why is it important?

Simply put, diversification means that your investment portfolio contains many different types of assets (your portfolio is a collection of financial investments). As an investment strategy, diversification is strongly encouraged for two main reasons. The first is that having a diversified portfolio can help to reduce your exposure to risk. For example, if you invest heavily in a single stock which then performs poorly, you could potentially lose a significant amount of money. However, if you diversify by investing smaller amounts in a variety of assets, your losses will be much less serious if one or even several of these assets drop in value. The other reason to pursue diversification is that, as studies have repeatedly shown, a diversified portfolio will yield higher returns on average over the long-term. This makes diversification particularly important for investors who are saving for a future financial goal, such as retirement or a child’s education. Keep in mind that it’s a good idea to speak with a financial professional in order to build a portfolio that meets your needs.

How can I build a diversified portfolio?

The good news about diversification is that it’s not as complicated as it may seem. There are many different steps you can take to build a portfolio that has a healthy mix of investments, including:

Choosing different asset classes—The simplest way to diversify your portfolio is through asset allocation. In other words, rather than investing in only one type or class of assets, you instead ensure that your portfolio contains a balance of different classes. Common asset classes that are a good fit for new investors include bonds, which are essentially loans made to entities such as a government or a company; stocks, which are ownership shares in a company; and commodities, which are products or basic goods such as wheat or gold. Other asset classes you can consider include real estate, which you can invest in via a real estate investment trust, and cash or short-term cash equivalents.

Selecting a mix of ETFs and mutual funds—If you’re just getting started with investing, it might feel overwhelming to try to choose a balanced mix of different asset classes. Another step you can take to more easily build variety into your portfolio is to choose a selection of exchange-traded funds (ETFs) and mutual funds. These investment vehicles are like a basket that already contains many different stocks, which offers you the benefit of automatic diversification. Some experts recommend choosing at least five different mutual funds (ETFs) and limiting your investment in any one of them to a maximum of 25% of your money.

Going beyond domestic options—Many new investors like to stick with domestic investments when starting out, such as well-known national companies. But investing in international markets can offer another way to diversify your portfolio. Stocks issued by non-US companies perform differently from their US counterparts because they are exposed to different market opportunities (and risks), so including international investments in your portfolio will help to protect you from forces that might affect some markets, but not others.

Investing in companies of different sizes—In pursuit of diversification, another consideration should be the size of the company. Having stocks from smaller, lesser-known companies in your portfolio alongside those from bigger and more mature companies is another great way to sensibly balance risk and reward.

What else do I need to know about diversification?

While diversification is a sound and highly recommended investment strategy, there are a few important things to understand in order to make the most of it. The first is that diversification is not something you can only do once. On the contrary, as your various investments grow—or shrink—you’ll need to rebalance your portfolio in order to optimize your investment vehicles. A common rule of thumb is to rebalance your portfolio at least twice a year.

Another caution worth heeding is not to spread yourself too thin when it comes to diversification. Investing in 20 or 30 different stocks will provide your portfolio with a healthy amount of diversification. However, investing in 100 different stocks makes it difficult to keep up with your investments and could minimize potential rewards.

Finally, keep in mind that diversification isn’t a one-size-fits-all strategy. Factors such as age, income level, and future financial goals all play a role in the choices you make when it comes to diversification, so it’s important that you build a diversified portfolio that’s right for you.

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