“Diversification is protection against ignorance. It makes little sense if you know what you are doing.”
― Warren Buffett
Every successful money manager emphasizes over the importance of diversification of investments. Diversification creates a protective shield for your investments during a market swoon. Moreover, the wavering stock prices and the economy have made it mandatory to allocate your investments strategically.
According to Investopedia.com, diversification is:
A risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio of different kinds of investments will, on average, yield higher returns and pose a lower risk than any individual investment found within the portfolio.
Diversification strives to smooth out unsystematic risk events in a portfolio so that the positive performance of some investments will neutralize the negative performance of others. Therefore, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated.
If you are planning to diversify your investments, it is important to understand the art of diversification and prepare a strategy for diversifying your investment.
Variety is the key to diversification
Many investors confuse diversification with the amount of investment. Diversification means having different variety of investments instead of the quantity. A properly diversified portfolio should have investments in real estate funds, stocks, cash, bonds, and international securities.
Why you should invest in these asset categories?
- Bonds: Bonds will help you gain a regular income stream.
- Stocks: Stocks are crucial for an overall growth of your portfolio.
- International securities: International securities can help you gain maximum returns from your investments in emerging economies.
- Cash: Cash ensures the stability of your portfolio.
How to divide your money among different asset categories?
It is important to invest in multiple assets. But, how do you determine the amount of money to invest in these categories? According to financial experts, it depends upon the age and risk tolerance capacity of the investor. Every investor should keep an emergency fund before investing the money into different asset categories. For a 20-year-old investor, the best strategy is to invest 80 percent in stocks and 20 percent in bonds. On the contrary, a 40-year-old investor should choose 60 percent stocks and 20 percent bond investments. You need to keep aside 5 percent from your stock and bond investments, and invest it in real estate investment trusts.
Diversify your asset categories by another level.
Once you have done the first level of diversification by choosing different asset categories, it is time to diversify a level deeper. While buying stocks, it is not sufficient to buy stocks of a single company. You should try to buy different variety of stocks for proper risk coverage. However, if you are not comfortable with the high trading fees, it is best to choose a financial product that offers diversified investments in stocks.
Choose Mutual Funds!
Mutual funds pool together the money of different investors and use this money for purchasing different stocks, real estate funds, international investments, and bonds. You can choose index funds for better returns, lower maintenance costs, and sufficient risk cover.
Justify your risk and return strategy.
A high return strategy might put your investments at risk. If you are nearing your retirement, you should allocate more money towards low-risk investments such as bonds. However, a 50-year-old investor has nearly 30 more years to invest, and it is best to bear a little risk with a 50-50 stock to bond ratio. You can consult a financial expert/portfolio manager for further advice.