So, what is diversification and how do you achieve it? This is a topic near and dear to my heart, as the name of this website implies. Diversification is more than just making sure that you don't put all your eggs in one basket, and diversification can mean a lot of things to a lot of people. Let's consider some examples to illustrate how most people look at diversification for their investments.
For example, let's say your portfolio consists of a number of US stocks in different market sectors, such as healthcare, technology, utilities. Or you invest in an index fund or ETF that follows the S&P 500. You are diversified, right?
Well, what if all of those stocks are all based in the US and then the US economy tanks?
Ok, well then you might buy some international stocks or index fund that follows foreign stocks. Now you're done, right?
Well, what if all stocks around the globe take a hit? After all, at the time of this writing, the global economy is currently under intense pressure due to high inflation, slowing growth, and supply chain issues.
As I mention in one of my previous blog articles, Benefits of Real Estate Investing and How to Start, real estate is a good way to diversify out of stocks that has numerous benefits such as cash flow, appreciation, and tax advantages. So now you buy a couple real estate properties or invest in REITs. You're diversified now, right?
Let's take a step back. Let's first define the risk that you, as an individual investor, is willing to take. This is called your risk tolerance.
Defining your Risk Tolerance
Let's say you have $10,000 to invest. You can do a lot with this money. But you should ask yourself some important questions, first.
What are your investment goals? Are you saving/investing for retirement or to purchase a new car or home? This will help answer the next two questions.
What is your investment timeline for this money? (i.e will you need to pull back this money in the next 1, 5, or 10 years?)
What is your risk tolerance? Are you comfortable riding through volatility or losing your investment? Stocks generally have higher volatility than fixed income assets and bonds.
Answering these questions will help guide you in your decision making process. Let's look at an example. Let's say you have $10,000 to invest. Here are some options for investing your hard-earned money:
You could take this money and put it in a high yield savings account. This will give you full access/liquidity to your money, but will only earn you about 1-2%, which is currently less than inflation. In this case, you'd actually be losing money. Not a good investment, even though your money is FDIC insured.
You could take this money and buy some bonds, such as some Treasury I-savings bonds. At the time of this writing, these bonds will give you 9.62%, since Treasury I-savings bonds calculate their return based on a formular that takes inflation into account. Pretty good considering that these are backed by the U.S. Federal Government.
You could take this money and invest in some stocks or ETFs. While the S&P 500 is down about 18% year to date, it is widely assumed that stocks will yield a return of about 7-10% on an annual basis in the long-term.
You could take this money and invest in a crowd-funding site such as Yieldstreet or Fundrise. While in 2021, Fundrise returned a whopping 25% return, their average return is about 10% on annual basis according to them. Keep in mind that Fundrise will make you pay a penalty of 1% you if you take your investment out in less than 5 years, as your money is being invested in a diversified portfolio of real estate properties (an illiquid asset).
You could take this money and buy or sell some options contracts. Options contracts are generally more volatile than stocks, but can earn a bigger reward and even stable cashflow if proper hedging strategies are implemented.
These are not your only choices, of course, but these example showcase a spectrum of the risk vs. reward profile that an investor may consider investing in to diversify. The key here is to learn about each of these investment strategies and pick some that align with your profile.
A diversified portfolio is simply a collection of investments in various assets or asset classes, that is tailored to you, with the goal of maximizing the return and reducing risk of the overall portfolio. In a diversified portfolio, certain assets will rise as others fall due to certain economic events.
For example, when the economy slows, bonds tend to fare better than stocks and equities. On the other hand, stocks are favored when the economy is growing. Another example, such has been seen in the U.S. housing market as of late, is that when supply outpaces demand, the value of homes rise because people are willing to pay more to own the home. As mentioned in a previous blog article, Using Technology to help organize your finances and create better habits, you can categorize your investments into high risk vs. low risk and/or using asset classes, and then calculate a percentage of those assets in your overall portfolio to get a holistic picture of your investing strategy.
Diversification, then, is the allocation of your portfolio based on the percentages of asset classes driven by your risk tolerance. The power of diversification is that typically each of these assets or asset classes are not correlated with each other and will provide different returns in different economic cycles. A diversified portfolio and a long-term investing mindset is your best defense against a recession or economic crisis.