Have you ever heard the saying “don’t put all of your eggs in one basket?” Most people apply this motto to the business world, but it also applies to investments. Savvy money managers will tell you that it’s important to spread your money around. Diversification protects against volatility, so if the market crashes, you won’t lose all of your assets in one fell swoop.
But how do you diversify your portfolio?
Variety Trumps Quantity
When talking about diversification, the focus is on the variety of investments – not the quantity. The goal is to invest in different types of investments, such as:
- Real estate funds
- International securities
Bonds will bring you income, while stocks will help your portfolio grow. Real estate will hedge against market declines and inflation. International investments also hedge against volatility and provide growth. Of course, cash will give you security and stability.
Some investors also use commodity and forex trading to diversify their portfolios.
How Much Should You Invest in Each Type of Investment?
The goal is put your money into a variety of investments, but how much should you put into each category? Should you split your money evenly across the board? Not quite.
There’s a simple rule that many investing gurus follow when allocating their money:
- Subtract your age from 100.
- Put the resulting percentage in stocks.
- Put the remainder in bonds.
So, if you’re 30 years old, you would put 70% into stocks and 30% into bonds.
Why does your age matter? When you’re young, you have more time to make mistakes and can take greater risks with your money. The closer you get to retirement, the less time you have to make mistakes. Allocating more money to safe investments, like bonds, will help ensure that you have money when you retire.
From here, you can diversify even further. Maybe you allocate 10-25% of the stock portion of your portfolio to international securities. You may take 5% of your stocks and 5% of your bonds, and then invest that 10% into real estate investment trusts (REITs).
So, the 30-year-old from our example may put 65% into stocks (15% of which is international), 25% into bonds and 10% into REITs.
Reviewing and Rebalancing
It’s not enough to diversify once. It’s important to periodically review and rebalance your investments to protect against risk. Without rebalancing, your portfolio may skew more towards one particular type of asset, usually stocks, which can leave you vulnerable to bigger ups and downs.
In addition to reducing risk, rebalancing also resets your asset mix to align with your appropriate risk level. As you get older, this may mean moving more of your portfolio into more conservative options.
Before you even get started with investing, you should clearly define your goals and your time frame while taking into account your risk tolerance. This will help you better diversify your portfolio with investments that make sense for your risk level.
Review your plan every year, or whenever your financial circumstances or goals change. This will ensure that your plan still makes sense and will help you reach your goals.