Portfolio Diversification: How to Protect Your Investments
This article is designed to be a general commentary on diversification and alternative investments in your portfolio. While the content is accurate, you need to discuss your personal circumstances with a financial advisor to determine if this is right for you.
What is Diversification?
Diversification is a key component of effective risk management – helping traders and investors enhance and preserve the value of their investment portfolio.
Diversification can help reduce exposure to the risk of loss, which ultimately can improve the stability and earning potential of an investment portfolio. For most investors, diversification helps them build a strong portfolio for long term results.
It aims to maximize returns by investing in different areas or sectors that would each react differently to the same event. Most investment professionals agree that, although it does not provide any guarantee against loss, diversification is essential in achieving your long-term financial goals while minimizing your risk.
The Benefits of Diversification
Diversification can help protect you against events that would affect specific investment types. For example, let’s look at industry-specific risk found in energy stocks. If the price of oil falls, it’s possible that a lot of companies working in gas and oil may see their share prices fall. If you’ve also invested in non-energy assets, that decline in value is less likely to have an impact on your portfolio.
Diversification does not guarantee returns or protect against losses although it can help mitigate some, but not all, risk. For example, systematic risks – which include inflation, interest rates or geopolitical events – can cause instability in markets and affect the broader economy and market overall.
7 Strategies to Diversify your Portfolio
1. Determine Correlation
It’s important to consider the correlation between the investments in your portfolio. Even if you own many different investments, if they all trend up or down together, your portfolio isn’t appropriately diversified. For instance, high-yield bonds often have a positive correlation with stocks. Therefore, a portfolio made up entirely of high-yield bonds and stocks is not well diversified.
2. Diversify across Asset Classes
Investing offers several asset classes to choose from, including:
- Equities (stocks)
- Fixed Income (bonds)
- Cash and Cash equivalents
- Real-world assets, including property and commodities
- Alternative investments: you can see a range of professionally managed alternative investment programs on trademakers.
These asset classes have varying levels of risk and return, so including investments across asset classes will help you create a diversified portfolio. Diversified investment portfolios generally contain at least two asset classes to remain effective.
3. Diversity within Asset Classes
Diversifying your portfolio across asset classes is one way to effectively manage your exposure, but diversifying within individual asset classes is potentially even more effective:
- Industry: If you invest in auto stocks, for instance, consider adding tech, biotech, utility, retail, and other sectors to your portfolio.
- Fixed income investments (bonds): Look for bonds with different maturities and from different issuers, including the U.S. government and corporations.
- Funds: While some funds track the overall stock market (known as index funds), other funds focus on specific segments of the stock market. If your goal is diversification, check what stocks your funds invest in to make sure you’re not overly exposed to one area or another.
4. Diversify by Location
Asset classes aren’t the only way to diversify. It’s a good idea to consider location and global exposure. Investing in and trading assets from different regions and countries can reduce the impact of negative market movements on your portfolio, reducing your risk from the economic conditions in one country as a result of one government’s economic policies.
However, do note that that diversifying your portfolio across different geographical regions can increase the risk to your investments.
Developed markets (like the UK and US) aren’t as volatile as emerging markets such as Brazil, China, India and Russia. Investing in international assets can increase your portfolio diversity, but you should make sure you understand and can accept the varying levels of risk involved.
5. Explore Alternative Investments
If you’re seeking additional diversification options, assets such as commodities and foreign exchange should be carefully considered.
- Commodity Investments are investments in physical goods, from gold to natural gas to wheat and even cattle.
6. Rebalance your Portfolio Regularly
Even the most diversified portfolio needs to be rebalanced. Over time, certain investments will gain value, while others may lose value. Rebalancing is a negotiation between risk and reward that can help your portfolio stay on track during market highs and lows.
7. Consider your Risk Tolerance
Your tolerance for risk can impact your approach to diversification. Generally, the longer your timeframe, the more you can weather short-term losses for the potential to capture long-term gains.
With rising rates, higher stock market volatility and inflation, you may need to think beyond the traditional 60/40 allocations, stocks, and bonds.
The Current Investment Landscape
Investors are faced with a host of challenges in today’s market. Whether it be a war raging in Europe, the prospect of higher inflation and interest rates, or an equity market that may look frothy after a relentless run higher – the way forward for traditional investments may not appear as appealing as it was in past years.
Against a backdrop of ongoing market volatility, it’s no surprise investor interest in alternative investments continues to grow given the diversifying power of the asset class.
When it comes to investing, you’re likely familiar with stocks and bonds, but there’s a whole universe of possibilities outside these traditional asset classes. Alternative assets, from hedge funds and private equity, to venture capital and rare collectables, allow investors to further diversify their holdings and pursue returns less correlated with the stock market.
What are Alternative Investments?
An alternative investment is a financial asset that doesn’t fall into conventional asset categories, like stocks, bonds and cash.
Alternative investments include private equity, venture capital, hedge funds, managed futures and collectables like art and antiques. Commodities and real estate can also be classified as alternative investments.
Buying many types of alternative assets has historically been limited to financially sophisticated investors such as institutions or high-net-worth individuals. This is because most alternative investments are not traded on public markets, and they’re typically unregulated.
How much should the typical investor commit to Alternative investments: The jury is out, but industry professionals will typically suggest 10% of total assets be invested in alternatives.
Advantages of Alternative Investments
- Low correlation. One of the greatest advantages that alternative investments offer is low correlation with traditional asset classes.
- Diversification. Thanks to low correlation to stock or bond markets, including alternatives in a portfolio can improve diversification.
- Lower Volatility. Since alternative investments are less exposed to the broader market, the impact of market volatility can be lower.
- Inflation Hedges. Some types of alternatives, such as gold, oil or real estate, can be effective in hedging inflation risk.
- Potentially Higher Returns. Since alternative investments entail a higher level of risk, they also offer the potential for higher returns.