A Beginner’s Guide to Diversifying Your Portfolio
Whether you dream of buying a second home, retiring abroad, or paying for your children’s college, investing can help grow your wealth, allowing you to achieve your goals. Diversifying your portfolio is one strategy that can help you accelerate your returns, weather downturns, and build toward your future plans.
Understanding Investment Portfolio Diversification
Diversifying your portfolio is akin to “not putting all your eggs in one basket.” In other words, diversification means spreading your money across the 11 investment sectors; different industries, such as entertainment, oil, and media; and different vehicle types, such as stocks, bonds, and mutual funds.
There are many benefits to diversification, but the primary one is managing risk. Markets go up and down all the time, but individual sectors, industries, and investment types don’t necessarily follow the same timelines. A variety of investments helps protect you from dips in one sector or industry while maximizing returns in another.
For example, imagine pharmaceuticals and gas utilities are thriving, but software is lagging. With investments across all of these sectors, you ensure your portfolio can still realize gains, while withstanding some loss. Although diversifying doesn’t prevent risk, this strategy does lower your overall risk by placing your eggs in many baskets.
Stocks, Bonds, or Mutual Funds?
With diversification, you have lots of options. Whether you engage a financial professional or prefer DIY investing, understanding all the investment choices available to you is a critical first step.
Here’s a cheat sheet to jump-start your knowledge on investment basics:
- Stocks: Also known as an equity, stock is owning a piece of a publicly-traded company. Stock prices or shares can range from single digits to hundreds of thousands of dollars. The key is to invest in a variety of individual stocks across many sectors.
For example, making huge bets on two Consumer Packaged Goods (CPG) companies may seem like a sure thing, but these industries face the same pressures and therefore the same market risks. For a built-in mix of individual stocks, consider mutual funds.
- Bonds: These lower-risk investments are equivalent to a loan that will be paid back in a set timeframe. That loan could be to a company or a government. On the upside, you’ll gain interest as the loan ages, but with lower risk comes lower, and often slower, returns.
- Mutual Funds: If you have a 401(k) already, it’s likely you have a mix of mutual funds. A mutual fund is a variety of individual stocks and bonds that are packaged together. Some mutual funds are managed by a financial professional, while others track the performance of a stock market index, which means lower fees than an actively managed mutual fund.
Target Date Funds are also a class of mutual funds that seek to grow assets for a future date, e.g. retirement. This class of funds typically invests in riskier stocks when you’re young and grows more conservative with more bonds as you age.
- Exchange-Traded Funds (ETF): Similar to a mutual fund, an ETF is a mix of investments. However, they do behave similarly to an individual stock in that they are traded daily and are purchased at a share price. ETFs often have a lower minimum investment than a mutual fund.
- Foreign Investment: Diversifying your portfolio also extends to the geography of where you spread your wealth. Just as you should avoid investing solely in one industry, like automotive, it’s wise to invest outside the U.S. Many emerging markets around the globe play a significant role in economic growth. The BRIC (Brazil, Russia, India, China) “account for roughly 40% of production globally.” The other advantage is these markets often experience highs and lows independent of the U.S. market.
- Real Estate: As a homeowner, you know the value of owning your home. But real estate is also a sound investment to grow your wealth. Whether buying a second home, flipping a home to sell for a profit, or investing in REITs, real estate is a reliable long-term investment opportunity.
- Your Own Business: Investing in your own business venture has multiple benefits in addition to the monetary ones. Having greater control of your income and your retirement options are just a few of the benefits of starting and growing a small business.
How to Start Diversifying Your Portfolio
The first step to investing is getting on strong enough financial footing that you’re ready to invest. According to financial coach Chris Hogan, “As long as [your money is] tied up in monthly debt payments, you can’t build wealth.” Your investment strategy should look something like this:
- Pay off bad debt. Bad debt, like high-interest credit cards, can easily snowball and have debilitating effects on your credit score and can even impact your job prospects. Debt-free may feel unattainable but there are practical steps you can take today to see the light at the end of the tunnel sooner.
- Build a rainy day fund. Once you’re in the black in terms of debt, it’s a sound idea to squirrel away money for a rainy day. Unforeseen disasters and unwelcome surprises happen, such as leaky pipes, medical expenses, accidents, and unemployment. The best part of a rainy day fund is it can help you stay out of debt, enabling you to pay for that hospital visit or car repair bill without taking out a loan or putting expenses on high-interest credit cards.
- Secure the money to invest. As a homeowner, you may be sitting on the means to take care of debt, and potentially have money left over to build a rainy day fund and invest. Accessing your home equity can give you the cash needed now to realize your other financial goals. You have several ways of unlocking your home equity, including debt-free options like a Hometap Investment.
As with any investment strategy, diversification shouldn’t take a set-it-and-forget-it approach. Many financial experts advise rebalancing every six months to a year depending on performance, your financial situation, and your personal goals.
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The opinions expressed in this post are for informational purposes only. To determine the best financing for your personal circumstances and goals, consult with a licensed advisor.