The top 10 things to know about diversification plus the biggest mistake people make when diversifying a portfolio.
If there is one takeaway from the collapse of the financial system in 2008, it is the importance of not putting all of your eggs in one basket. A well-diversified portfolio will ensure that if a situation similar to that in 2008 were to happen again, you wouldn’t lose everything like some individuals did.
The definition of what constitutes a well-diversified portfolio is easily misconstrued. If you’ve never diversified your current portfolio (or assembled one for the matter) you’re the first to know that it can be an arduous task. In an effort to help our readers better understand and navigate the complicated strategy known as portfolio diversification, we spoke with our resident certified investment strategist. This individual gave us their top 10 things to know about portfolio diversification. They also revealed to us the one thing you should never do when diversifying your portfolio.
1. Know your end game
There is no one specific investment strategy that works for everyone. Look at your current situation and find what your personal long-term goals are. Your portfolio should have a level of instability you are comfortable with. If you’re not too inclined with high-risk investments, you’d probably be better suited for low-risk style investments.
2. Your first focus is to reduce risk
The ultimate goal of a diverse portfolio is that in the event you have one asset under-performing, you have another that makes up by over-performing. Think of it as a game of roulette—if you only bet on one space, the odds are against you. By betting on multiple spaces, you increase your odds for success.
3. The second is to enhance returns
Another reason why you want to have a wide range of investments is so that when you have outperforming assets, they enhance your overall returns. Possessing a broad assortment of assets not only protects you, it also allows you to take advantage of the ones doing well.
4. Look for investments in different asset classes
Conventionally, a diverse portfolio has been comprised of two asset classes—equities and bonds. In recent years, investors have been breaking the conventional mold by adding in investments from other classes like real estate, commodities and even foreign currency. By investing in different classes, you’re able to keep correlations between assets aligned.
5. Dive deeper into classes by investing into sectors
Similar to the above belief, by investing into multiple sectors within classes, you can achieve the same, if not better results. The goal here is to be evenly divided along each class’s sector.
6. Choose assets that succeed in different markets
You don’t want to only invest in assets that do well in a specific type of market—whether it is bull market, bear market or a sideways market. You want to own some assets with negative correlations. So if one flourishes in a bull market, the other does the opposite in a bear market. When the coin flips, it’ll balance out. A managed futures account is a good investment that is diversified in its own right.
7. Have plan in place to balance down the road
With a well-constructed portfolio, periods of unbalance are to be expected; it’s a sign your portfolio is on the right track. Over time, outperforming assets generally will start comprise a large percentage of your portfolio. When you balance out your portfolio, you should sell out of the high performing assets and buy into the under-performing assets. Basically, you’ll be selling high and buying low.
8. No borrowing between classes
Your instincts will tell you to abandon an investment that isn’t immediately paying off in order to strengthen the ones that are. This is a common mistake that catches many investors. It is because of this you should have a re-balancing plan. With a solid re-balancing plan, you need not to listen to these instincts. The key is to stay disciplined to your re-balancing plan.
9. Research your investment’s history
This practice is known as back-testing your portfolio. By doing this, you can see what correlations exist within your portfolio and how those correlations perform within certain markets. But always keep in mind this isn’t an “end all, be all” principle as past performance isn’t a certainty. Think of it as an outline, but always consider the current market conditions first.
10. Assess correlations intermittently
One certainty of markets is that they are constantly changing. Conflicting correlations exist all the time. To insure your portfolio stays current with trends, a re-balancing procedure may not be enough. This is where periodic correlation testing comes into play. As markets and correlations change, you should make changes to your portfolio accordingly.
The one thing you should never do when diversifying your portfolio
Perhaps the biggest mistake you can make when diversifying your portfolio is letting your emotions get in the way of major decisions. Your emotions will naturally get in the way because you are gambling your life savings with the hopes of securing yourself a better future. Your instincts will tell you to focus on what will make the most money “now”. When in reality, you need to be focusing on the future. Develop a plan and stay disciplined to it; don’t waver. There will be ups and downs, but if you diversify properly, you’ll end out on top.