Why & How to Diversify Your Portfolio? (6 tips)
Diversification is a strategy that involves investing in different types of assets or sectors to reduce the overall risk of your portfolio. It is based on the idea that not all investments will perform well simultaneously and that spreading your money across various categories can reduce the impact of market fluctuations and volatility.
Diversification can help you achieve several benefits, such as:
1. Reducing your exposure to specific risks
Avoiding placing all your eggs in one basket and becoming subject to a single event or trend that could damage your returns requires investing in various businesses, geographies, or asset classes. A legislative change, a cyberattack, or a change in consumer preferences, for instance, might cause you to lose a lot of money if you just invest in technology stocks. However, if you also make investments in other industries, like healthcare, energy, or consumer staples, you can lessen the effects of such occurrences and maintain portfolio balance.
2. Enhancing your long-term returns
By investing in different types of assets with different risk-return profiles, you can optimize your portfolio’s performance over time. For example, if you invest only in bonds, you may enjoy a steady income and low volatility, but you may also miss out on the higher growth potential of stocks. However, if you also invest in stocks, you can benefit from their higher returns in the long run while still having some stability from your bond holdings. Another example would be our strategies; our AP Hedged Strategy offers more of a conservative approach with shorting stocks in order to lower drawdown at the expense of higher gains; however, our AP Aggressive Strategy offers a more aggressive approach without shorting any stocks to maximize capital gains.
3. Adapting to changing market conditions
By investing in different types of assets that respond differently to various economic and market factors, you can adjust your portfolio’s allocation according to your goals and risk tolerance. For example, if you invest only in stocks, you may face higher volatility and uncertainty during periods of recession or market downturns. However, if you also invest in bonds, cash, or alternative assets, such as gold or real estate, you can reduce your portfolio’s sensitivity to market movements and preserve your capital.
How to Diversify Your Portfolio
Diversification cannot be approached in a one-size-fits-all manner since every investor has unique goals, time horizons, and risk tolerance. However, the following general rules should be followed:
1. Diversify across asset classes
The most basic level of diversification is to invest in different types of assets, such as stocks, bonds, cash, and alternatives. Each asset class has its own characteristics and advantages and disadvantages. For example, stocks offer higher returns but also a higher risk; bonds offer lower returns but also a lower risk; cash offers liquidity and safety but also low returns; and alternatives offer diversification benefits but also higher costs and complexity. It would be best to allocate your portfolio across these asset classes according to your desired risk-return trade-off.
2. Diversify within asset classes
The next level of diversification is to invest in different subcategories within each asset class. For example, within stocks, you can invest in various sectors (such as technology, healthcare, and energy), regions (such as the US, Europe, and Asia), or styles (such as growth, value). Within bonds, you can invest in different maturities (such as short-term and long-term), credit ratings (such as investment-grade, junk), or issuers (such as government and corporate). Within alternatives, you can invest in different types (such as gold and real estate). It would be best to diversify within each asset class according to your preferences and expectations for each subcategory.
3. Diversify across time
The final level of diversification is to invest in different periods or stages of your life. For example, you can invest in different strategies (such as buy-and-hold, dollar-cost averaging) or adjust your portfolio’s allocation as you approach retirement or other financial goals. It would be best to diversify across time according to your changing needs and circumstances.
Diversification neither serves as a guarantee against losses nor a replacement for careful consideration and investigation. However, it is a strong instrument that can assist you in lowering the risk of your portfolio, boosting its returns, and adapting to shifting market conditions. By following these recommendations, you can build a diverse portfolio that meets your specific needs and objectives.