The Ultimate Step-by-Step Guide To Diversify Your Investment Portfolio
If you are a seasoned investor, there will be this one phrase that you would have heard and read a thousand times.
Or if you are a new investor, I’m telling you NOW.
“Don’t put all your eggs in one basket”.
This old adage illustrates the importance of diversification.
Well, we all know that we NEED to diversify our investment portfolio.
And that it is extremely crucial to do so.
But the real question is, HOW?
As a noob who just started my investment journey early this year, this has been the biggest question mark to me.
But first, let’s evaluate what it means by having a diversified portfolio.
What Is A Diversified Investment Portfolio?
Our investments are subjected to different economic influences at different points of our lives.
And different asset classes show varying returns in the same situation.
By diversifying, we are basically building a portfolio that will have components that do well in different economic situations.
So that in any one economic scenario, we don’t lose all our money.
This is because the negative returns from one asset can be compensated by the positive returns in another category.
Essentially, we are forming a diversified investment portfolio that earns the highest return for the least risk.
The Ultimate Guide To Diversifying Your Investment Portfolio
Diversification is not just about adding as many assets to your portfolio.
It is not the more, the merrier (like how bubble tea is).
Instead, it is about holding investments that move independently or opposite from one another.
So, if your entire portfolio moves together, you aren’t diversified.
With that, I have listed down some ways that you can diversify your investment portfolio by.
1. Type of Asset Classes/Asset Allocation
Different asset classes have different levels of risk and return, of which they will behave differently over time.
As such, investing in different types of asset classes will help to diversify your portfolio.
Here are some of the common asset classes that many invest in:
- Property/ Real Estate Investment Trusts (REITs)
Or if you are too lazy (like me) to analyze everything one by one.
Given that they are already a basket of different companies, to begin with.
Which makes itself already diversified.
While there isn’t a one size fits all method of building a diversified portfolio with funds.
Steven A. Cohen suggests using the 5/25 rule as a guide:
“Stick to five different asset classes and don’t have more than 25% of your money in one of them.”
Over concentration into a single country poses a very high risk.
Given that different countries experience different financial cycles at each point in time, foreign markets seldom move in perfect tandem with each other.
This allows the losses made in one market to be offset by the gains in another.
As such, geographical diversification helps to reduce the overall level of volatility and exposure to external factors significantly.
With the onset of Black Monday 2020, the stocks of many companies have plunged.
While some others have risen significantly.
If Investor A had invested ALL his life savings into Singapore Airlines (SIA), the exponential fall in share price could potentially cost him everything.
In comparison, if Investor A had invested half of his savings to SIA and the other half to a teleconferencing company like Zoom.
The losses in SIA may be offset by gains in the stock of Zoom.
Hence, there is an evident need to diversify our investment portfolio by sectors and industries.
4. Market Cap of Company
Market Cap of a company refers to the total value of all of a company’s shares of stock.
In other words, the size of the company in terms of market value.
Similarly, companies with different market caps have their own unique risk and return characteristics.
This results in them performing differently depending on market conditions.
As such, diversifying among companies with various market caps can reduce risk and volatility in a portfolio.
Generally, it will help to maximise investment returns over the long haul.
It is also important to continuously build and add to your portfolio regularly.
A good way would be to invest in a Regular Shares Savings Plan which utilises the concept of dollar-cost averaging.
By investing your money regularly, it will help to smooth out the peaks and valleys created by market volatility over time.
Using this strategy, you will be able to buy more shares when prices are low, and fewer when prices are high.
The Problem of Over-Diversifying Your Investment Portfolio
However, once the unsystematic or diversifiable risk has been eradicated, there is no further benefit derived from adding more assets into the portfolio.
As such, the portfolio will be over-diversified.
So, How Much Diversification Is Enough?
There is no hard-and-fast rule for us to follow when it comes to diversifying our portfolio.
We should always aim for a mix of growth, value and core stocks and economic sectors to maximise diversification.
To prevent our portfolio from being over-diversified, we should adopt the following habits:
- Read up and be constantly up to date with the latest news
- Review and rebalance your portfolio regularly
It is crucial for us to rebalance our portfolio every quarter with due diligence.
Or at the very least, annually.
That way, you can reallocate funds from investments that have outgrown their desired allocation to ones that have underperformed.
Ultimately, the percentage and amount are up to our own risk appetite!
For those who have just started on your investment journey, you can consider investing in robo-advisors!
Thoughts on Diversification
While diversification does help to lower the investment risks in the long term.
It does not guarantee better returns or fewer losses.
It is merely a technique that can help us reach our long term financial goals.
Similarly, this concept can be easily applied to other areas of personal finance!
With that, invest safely, and wisely!