In this article, we will explore how to easily diversify your portfolio.
An investor without any specific expertise should seek to diversify his or her portfolio so as to protect themselves from the inherent risks of the stock market and the volatility of the broader economy.
In this article, I will strive to answer the following questions beginners may have about diversification:
- What is diversification?
- What are the different ways to diversify a portfolio?
- What are the downsides of diversification?
- How to diversify a portfolio easily and as inexpensively as possible?
1. What is diversification?
Diversification is a strategy which seeks to include a variety of investments within a portfolio so as to minimize the inherent risks of any given asset: the positive performance of one or more assets neutralize the negative performance of others.
A diversified portfolio minimizes its risk profile by investing in different asset classes as well as by investing in diverse products within the same asset class. The idea is that a diversified portfolio will generate, on average, a higher long-term return than a non-diversified portfolio.
For diversification to work, your portfolio must include assets that are not all positively correlated to each other. That is to say, you want assets that react differently to changing market conditions. If all of your assets move in the same direction at the same time, then your portfolio is not well diversified.
2. The Three Types of Diversification
There are three ways to diversify your portfolio: investing in different asset classes; diversifying within an asset class; and, investing abroad.
A. Diversification across asset classes
When you diversify across asset classes, you allocate certain percentages of your capital to different investments.
Here is a list of the most common asset classes:
- Equities (stocks)
- Bonds (state or corporate)
- Real estate
- Raw materials (lumber, steel, grain…)
- Cash or its short-term equivalent (Treasury Bills, Certificates of Deposit, the Money Market, savings accounts…)
- Precious metals (gold, silver, platinum…)
- Cryptocurrencies (Bitcoin, Ethereum…)
- Fine art
- Jewelry & luxury watches
- Any other asset that may generate a return on investment (antiquities or vintage items that can be sold at auction, such as rare or first edition comic books)
There is no hard and fast rule for how you should invest in each class. How much of your capital you invest in each asset class will depend on your personal financial goals and risk tolerance. You may decide to invest in each asset class or only in the ones that interest you.
Keep in mind that some asset classes are higher risk than others and sometimes require a certain degree of expertise to make knowledgeable investments (for example, investing in works of fine art).
B. Diversification within an asset class
It is possible to diversify a portfolio within an asset class.
To do this, purchase products (or stocks) that are not positively correlated to each other. This means that when one asset rises, another may fall or remain neutral—in other words, they react different to similar market conditions.
Here are some examples:
- Stocks: technology (growth) or food (stability and anti-crisis); dividend aristocrats (revenue) or small cap stocks (betting on future profitability)
- Bonds: state bonds from developing countries (security) or from emerging countries (higher levels of risk); mature corporate bonds versus risky corporate bonds; state bonds or corporate bonds
- Real estate: leasing apartments on a yearly basis versus seasonally; investing in parking versus buildings, etc.
Each asset class consists of different products that allow you to diversify your portfolio and to spread out and minimize your risk profile.
C. Diversification by investing abroad
Investing abroad can be more or less difficult depending on the asset class you wish to invest in.
For example, investing in real estate abroad can be expensive and difficult without the appropriate network in place.
When it comes to the stock market, investing abroad can be easy to do by purchasing ETFs (more on this in Part 4.).
3. The Downsides of Diversification
There are 3 main downsides to diversifying your portfolio: time, expense, and short-term returns.
A. It can be time consuming
The more assets you have in your portfolio, the more time you will need to manage them all.
This can be both tedious, as the management of many assets is time-consuming, and expensive, if you decide to delegate to a third-party.
Before you venture into the world of diversification, determine how much time you have to dedicate to the management of your different assets and whether hiring help is an expense you are willing to make.
B. It can be expensive
Investing in several asset classes may result in high costs.
For example, investing in real estate requires you to have a lot of capital available on hand; and, buying and trading a large number of stocks brings with it more transaction fees and taxable events.
Be aware of these potential extra fees when you start to diversify.
C. Lower short-term returns
While diversification can minimize your losses, it can also negatively affect your rate of return in the short-term.
By diversifying your portfolio, you reduce the amount of capital you can invest in each particular asset. This is the trade-off of diversification: if one asset crashes, it won’t have a huge impact on your overall portfolio…, but the reverse is equally true.
Remember that investment is a constant balancing act between risk and return. The higher the risk, the higher the potential future return. The lower the risk, the lower the potential future return.
You must decide, depending on your financial goals and risk tolerance, which trade-off to make for each asset you purchase.
That being said, keep in mind that over the long-term, diversified portfolios tend to generate better returns than non-diversified portfolios.
- Diversification limits short-term returns, requires a significant time commitment to manage, and implies more transaction and higher commission fees.
- Diversification lowers the overall risk profile of your portfolio and offers higher returns over the long term than non-diversified portfolios.
4. How to easily diversify?
Warren Buffet recommends that investors purchase low-cost ETFs that track the performance of major stock markets.
This is arguably the single best way to generate maximum returns with minimal risk.
You can find more in-depth information about these types of ETF in my previous articles.
Stock Market ETFs
This is one of the most popular ETFs in the world: It tracks the performance of the 500 largest American companies listed on the US stock exchanges, has very low fees and generated an average annual return of 13.35% over the past 10 years.
This ETF tracks the performance of the 100 largest non-financial companies listed on the Nasdaq and generated a total return of 497% over 10 years.
This ETF tracks the performance of 1293 companies listed on the emerging market It is more volatile than the others and generated an average annual return of 3.5% over 10 years.
This ETF tracks the performance of over 1500 world-wide companies listed on the stock markets of developed countries.
It also has very low fees and generated an average annual return of 9.68% over the past 10 years.
There are hundreds of ETFs that track the performance of companies and products for every geographical area and sector.
Research and invest in the ones you prefer.
Real Estate ETFs
To invest in the real estate market without needing to purchase buildings yourself, look into REITs (real estate investment trust)
This ETF tracks the performance of REITs world-wide.
It has management fees of 0.14% and an average annual return of 3.86%.
This is a great ETF for diversification outside of the USA.
It tracks the performance of over 600 REITs listed across the world, has management fees 0.12% and a total return of 67% since 2011.
This ETF invests in U.S. investment-grade company bonds. It generated an average annual return of 3.36% over the past 10 years.
When it comes to cryptocurrency, especially as a beginner, it is best to keep things simple and invest in cryptocurrency that is well-known, such as ETH, BTC, and Binance Coin. If you are a bit more adventurous, you can explore the top 100 coins and invest in the ones you think have real use cases and serious development teams.
One major trend to watch out for are Cryptocurrency ETFs. As cryptocurrencies become mainstream, investment funds and online brokers will offer crypto ETFs which allow you to invest in a basket of cryptos to track the overall performance of the market. These can be very interesting for people who want to diversify as broadly as possible, minimizing the risk of an inherently volatile crypto market.
Precious metals play an integral part of any well diversified portfolio. Indeed, they are universally recognized as stores of value and protect you from currency devaluation.
However, contrary to the other assets presented above, it is better to physically buy precious metals rather than investing in ETFs or paper derivaties.
Buy your gold, silver, or other metals from an authorized reseller and store it in a safe place.
Diversification is a very powerful strategy for generating good long term returns on your investments.
However, it is not a foolproof strategy and it requires thoughtful planning to be implemented effectively.
Every investor develops his or her own diversified portfolio in function of their investment objectives, risk tolerance and knowledge of asset classes and financial products.
Thank you for reading this article.
Disclaimer: I am not a financial advisor and this is not financial advice. Please do your own due diligence before investing in any asset.