Investing is an art form, not a knee-jerk reaction. Thus, the time to practice disciplined investing in a diversified portfolio is before diversification becomes a necessity. Here, more than most places, a good offense is your best defense and in general, a well-diversified portfolio combined with an investment horizon of three to five years can weather most storms.
Diversification is often described as the only free lunch in investing. By picking the right group of investments, you may be able to limit your losses. You may also reduce the fluctuations of investment returns without sacrificing too much potential gain. This article will focus on portfolio management tips on how to diversify portfolio investments.
First off, what is a ‘Portfolio’?
A portfolio is a laid-back or passive investment of securities in a portfolio. It is made with the expectation of earning a return. This expected return is directly related with the investment’s expected risk. A portfolio investment is distinct from direct investment, which includes taking a substantial stake in a target company and possibly being involved with its day-to-day portfolio management.
Portfolio investments can span a wide range of asset classes such as stocks, government bonds, corporate bonds, Treasury bills, real estate investment trusts (REITs), exchange-traded funds (ETFs), mutual funds and certificates of deposit. Portfolio investments can also include options, derivatives such as warrants and futures, and physical investments such as commodities, real estate, land and timber.
Breaking it down
The composition of investments in a portfolio depends on a number of factors. Some of the most important include the investor’s risk tolerance, investment horizon and amount invested. For a young investor with limited funds, mutual funds or exchange-traded funds may be appropriate portfolio investments. For a high net worth individual, portfolio investments may include stocks, bonds, commodities and rental properties.
Portfolio investments for the largest institutional investors such as pension funds and sovereign funds include a significant proportion of infrastructure assets like bridges and toll roads. Meanwhile, institutional investors generally need to have very long lives so that the duration of their assets and liabilities match.
11 Portfolio Management Tips to Diversify Your Assets
Diversification is a battle cry for many financial planners, fund managers, and individual investors alike. When the market is booming, it seems almost impossible to sell a stock for any less than the price at which you bought it. When the indexes are on their way up, it may seem foolish to be in anything but equities.
But because we can never be sure of what the market will do at any moment, we cannot forget the importance of a well-diversified portfolio (in any market condition). Here are the 11 tips on how to diversify your portfolio:
Know Your Risk Tolerance
Risk tolerance is a measure of your emotional appetite to take on risk. It is the ability to endure volatility in the marketplace without making any emotional or spur-of-the-moment investment decisions. Individual risk tolerance is often influenced by factors like age, investment experience, and various life circumstances.
Indeed, your risk tolerance can change over time. Certain life events can affect your ability to bear market volatility. You should promptly reflect these changes in your portfolio risk profile as they happen.
Understand Your Risk Capacity
Your emotional willingness and capacity to take on risk can often be at odds with each other. You may want to take more risk than you can afford. Or you could be way too conservative while you need to be a bit more aggressive. Factors like the size of savings and investment assets, investment horizon and financial goals will determine the individual risk capacity.
Set a Target Asset Allocation
Setting the right balance between your financial goals and risk tolerance will determine the target investment mix of your portfolio. Normally, investors with higher risk tolerance will invest in assets with a higher risk-return profile.
These asset classes often include small-cap, deep value and emerging market stocks, high-yield bonds, REITs, commodities and various hedge fund and private equity strategies. Investors with lower risk tolerance will look for safer investments like government and corporate bonds, dividends, and low volatility stocks.
To achieve the highest benefit from diversification, investors must allocate a portion of their portfolio to uncorrelated asset classes. These investments have a historically low dependence on each other’s returns. The U.S. large cap stocks and U.S. Treasury bonds are the classic examples of uncorrelated assets.
Reduce Your Concentrated Positions
There is a high chance you already have an established investment portfolio, either in an employer-sponsored retirement plan, self-directed IRA or a brokerage account. If you own a security that represents more than 5% of your entire portfolio, then you have a concentrated position. Regularly, individuals and families may acquire these positions through employer 401(k) plan matching, stock awards, stock options, inheritance, gifts or just personal investing.
There is a risk of having a concentrated position. It can drag your portfolio down significantly if the investment has a bad year or the company has a broken business model. Consequently, you can lose a significant portion of your investments and retirement savings.
Portfolio rebalancing is the process of bringing your portfolio back to the original target allocation. As your investments grow at different rates, they will start to deviate from their original target allocation. This is very normal and sometimes investments can have a long run until they become significantly overweight in your portfolio. Other times, an asset class might have a bad year, lose a lot of its value and become underweight.
Adjusting to your target mix will guarantee that your portfolio fits your risk tolerance, investment horizon and financial goals. Not adjusting it may lead to increasing the overall investment risk and exposure to certain asset classes.
Focus on Your Long-Term Goals
When practicing portfolio management, apply a balanced, disciplined, long-term approach that focuses on your long-term financial goals.
Sometimes we all get tempted to invest in the newest “hot” stock or the “best” investment strategy. Thus, we start ignoring the fact they may not fit with our financial goals and risk tolerance. Remember, focusing on your long-term goals will let you endure through turbulent times and help your wealth and assets grow.
Spread the Wealth
Equities are wonderful, but don’t put all of your investment in one stock or one sector. Create your own virtual mutual fund by investing in some companies you know, trust, and perhaps even use in your day-to-day life. People will argue that investing in what you know will leave the average investor too heavily retail-oriented. But knowing a company or using its goods and services can be a healthy and good approach to this sector.
Consider Index or Bonds Funds
Consider adding index funds or fixed-income funds in the mix. Investing in securities that track various indexes make a wonderful long-term diversified investment for your portfolio. By adding some fixed-income solutions, you are further hedging your portfolio against market volatility and uncertainty.
Add to your investments on a regular basis. Lump-sum investing may be a sucker’s bet. If you have $10,000 to invest, use dollar-cost averaging. This approach is used to iron out the peaks and valleys created by market volatility. You invest money on a regular basis into a specified portfolio of stocks or funds.
Know When to Get Out
Buying and holding and dollar-cost averaging are complete strategies. However, just because you have your investments on autopilot does not mean you should overlook the forces at work. Stay current with your investment and stay used to overall market conditions. Know what is happening to the companies you invest in.
Keep a Watchful Eye on Commissions
If you are not the trading type, understand what you are getting for the fees you are paying. Some firms charge a monthly fee, while others charge transaction fees. Be aware of what you are paying and what you are getting for it. Remember, the cheapest choice is not always the best.
Investing can and should be fun. It can be educational, informative and rewarding. By taking a disciplined approach and using diversification, buy-and-hold and dollar-cost-averaging strategies, you may find investing very worthwhile, even in the worst situations.
Overall, a well-diversified portfolio is your best bet for consistent long-term growth of your investments. It protects your assets from the risks of large declines and structural changes in the economy over time.
Monitor the diversification of your portfolio. Make adjustments when necessary and you will increase your chances of long-term financial success.
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