When it comes to investing, diversification isn't just a buzzword. It's a strategic move that can make the difference between financial security and volatility.
No matter where you’re at in your investing journey, it’s good to get familiar with portfolio diversification. Ask any investor and they’ll tell you: this is the bedrock of any solid investment strategy.
Here, we’ll help you get to know portfolio diversification and how you can start applying it to help you manage investment risk and potentially maximise your returns.
What does a diversified portfolio mean?
Portfolio diversification is essentially the act of investing in a range of asset types. For example, as opposed to only investing in stocks, a diversified portfolio would consist of a mixture of stocks, bonds, property, and precious metals.
If you’re like us and you love a pie chart, here’s a visual example of a diversified portfolio just for you.
Why Should I Diversify My Investment Portfolio?
Ever heard the phrase, “Don’t put all your eggs in one basket?”. Well, that is what portfolio diversification is really about.
It’s about spreading your risk across multiple investments, as opposed to putting everything in one place.
And having different kinds of assets is often more stable and, on average, brings higher long-term returns.
That’s mainly because different investment assets respond differently to market conditions. So having more than one type of asset reduces the risk of significant losses and increases the potential of overall value growth.
OK. So, how can I diversify my portfolio?
When it comes to diversifying your portfolio, there isn't a one-size-fits-all approach.
The right strategy for you will depend on your financial goals, risk tolerance, and general market conditions.
However, there are some popular strategies that you can build upon to create your diversified portfolio. Just bear in mind that you will likely need to tailor elements of each strategy to make them work for you.
Some popular diversification strategies include:
- Asset Allocation Diversification
The simplest and most common portfolio diversification strategy is investing in different types of assets like stocks, bonds, real estate, and precious metals.
Each type of asset has its own risk and return profile, so by having a mix you reduce the impact of poor performance in just one area.
- Sector Diversification
You can also diversify within an asset type. For example, in the stock market, you can invest in various sectors such as tech or healthcare. Or when investing in precious metals there is gold and silver.
Each sector can be affected by market conditions differently. So by investing in more than one, you protect yourself.
- Geographical Diversification
Different regions of the world can have different economic cycles and experiences. By investing in various global markets, you're not relying solely on the well-being of one economy. If one market takes a hit, your investments in other regions might provide a cushion.
You can also take advantage of different VAT and tax rules in other countries. For example, there is no tax to pay in Switzerland if you invest in gold there.
- Alternative Investments
Beyond traditional asset types, there are also investments like hedge funds, private equity, or real estate, that you can invest in.
These add a layer of diversification as they will be impacted by financial and market changes in a different way to your other assets.
- Dynamic Rebalancing
Imagine your money is like a mix of fruits in a basket. Over time, some fruits might grow bigger (earn more) and others might shrink (earn less).
You'd want to rearrange (or rebalance) your fruits every so often to make sure no fruit takes up too much space or gets too small. Why? Because if one fruit goes bad, you don't want it to spoil the whole basket.
Keeping a balanced mix helps protect your basket (portfolio) overall. So, by adjusting, you ensure you're not putting all your bets on just one type of fruit.
Which portfolio diversification strategy works best?
The classic portfolio
The classic 60/40 portfolio has been the mainstay of investment strategy for decades.
That’s 60% higher risk, higher return assets such as some stocks, and 40% of lower risk and lower return assets such as precious metals.
But over the last few years, some major investment management companies like BlackRock are warning that the 60/40 portfolio no longer fits today’s changing markets.
That’s because recent factors, like the 2020 COVID-19 pandemic, caused global economic shifts that spurred market volatility. The cost of keeping the world’s economies afloat during lockdowns has meant inflation is driving prices higher and higher. Coupled with the fact that many people don’t have the income to make investments, stock prices have dropped.
This, in turn, has caused many investment firms and experts to believe that the traditional 60/40 approach might not be the best. Because, with market volatility, stocks rollercoaster, so relying on them for 60% of your portfolio can be a nail-biting ride.
Luckily, you’re not limited to just one diversification strategy and there are plenty you can peruse when choosing the right one for you.
What else is out there?
These three portfolio diversification strategies reduce stock investments compared to the 60/40 portfolio, so you can worry less about market volatility:
- 55/35/10 portfolio: This strategy allocates 55% of your portfolio to higher risk, higher return assets such as stocks, and 35% to lower risk, lower return assets such as bonds and precious metals. The final 10% then goes towards real estate. Like the 60/40, it can help you to achieve higher returns over the long term, but it also comes with less risk than the 60/40 portfolio.
- 40/30/30 portfolio: This allocates 40% of your portfolio to stocks, 30% to bonds, and 30% to alternatives like precious metals. It’s a good compromise between risk and return and can help protect your portfolio against inflation.
- 30/30/30/10 portfolio: This allocates 30% of your portfolio to stocks, 30% to bonds, 30% to real estate, and 10% to alternatives such as gold and other precious metals. This is a more diversified approach and helps reduce your risk even further. This is a popular approach for those who are saving for retirement.
Choosing the right strategy for you
The best portfolio diversification strategy will depend on your unique circumstances and risk tolerance. Consider talking to a financial advisor for tailored advice.
However, here are some things you can think about when choosing a portfolio diversification strategy:
- Your age: Younger investors may be able to take on more risk, while older investors may prefer to reduce their risk.
- Your income: Your income will determine how much money you can invest.
- Your investment goals: What are you hoping to achieve with your investments? Are you saving for retirement, a down payment on a house, or something else?
- Your risk tolerance: How much risk are you comfortable taking with your investments?
There is no one-size-fits-all portfolio diversification strategy, but looking into assets beyond stocks, like precious metals is a great place to start.
Diversifying with precious metals
Even in the aftermath of COVID-19, precious metals have retained more value than other types of investments.
Traditionally, during inflationary periods, precious metals like gold and silver retain their value. Although the value of gold initially dropped when COVID-19 lockdowns temporarily halted gold mining, it rebounded to reach an all-time high in 2020. Since then, the value of gold has consistently remained at elevated levels.
Whether you’re buying gold in Switzerland or buying up property in the UK, diversifying your portfolio is an important investment strategy. Doing it successfully can help you to manage risk and increase potential returns.
Success is all about balancing risk. For example, if you’re thinking of adding riskier assets such as cryptocurrencies to your portfolio, you should also consider balancing this risk with other safer and more stable assets, like gold and silver. That’s because investment assets like precious metals offer a historical hedge in periods of economic uncertainty, like COVID-19. This can offset the volatility in your other assets, like stocks, which will take more of a hit.
So, no matter how experienced you are as an investor, diversification is a smart way to add stability and growth opportunities. Start diversifying your portfolio with precious metals today.