You may have heard that old real estate adage: location, location, location. But when it comes to the overall health of your investment portfolio, there’s another mantra you should live by: diversify, diversify, diversify.
Diversifying your investment portfolio is a crucial hedge against risk, and it maximizes your returns. Ray Dalio, manager and founder of one of the biggest funds in the world, calls this the Holy Grail of investing.
At publishing, the stock market is hitting all-time highs. As the pendulum swings, some experts expect a recession while others predict a soft landing. Either way, diversification is key to protecting yourself from future economic downturns.
But how does one go about diversifying? Without guidance, it can be so overwhelming that we prevent ourselves from taking actionable steps. That’s where we here at Passive Income MD come in.
Today, we’ll look at the basics of building a successful diversified portfolio, provide tips on how to diversify assets in a way that safeguards against volatility while maximizing returns, and answer the most frequently asked questions I receive.
What is Investment Diversification?
To diversify your investments is to spread them around, as opposed to throwing all of your eggs in one basket—or all your money in one investment deal. With diversification, if one investment “tank” runs dry, you’ll still have the rest of your assets safe in other areas.
While the term “diversification” seems simple enough, there are so many variables and what-ifs. How do you do it? When? Why and for what benefit? Most financial advisers will tell you that diversification means mixing your investments between different securities or asset classes, which is true. But to diversity intelligently, you also need investments that behave differently than one another. Why? Because in an economic downturn, like-investments tend to be impacted in the same way.
The Basics of Diversification
A diversified portfolio typically includes a combination of the following asset classes.
- US stocks
- International stocks
- Bonds
- Real estate
- Commodities
- Alternative investments
How to split these assets within a portfolio—as well the split of different investments within each asset class category—is prioritized by variables depending on your situation. Variables include these three determining factors: investment time horizon, investment goals, and risk tolerance.
For example, if someone has a short investment time horizon, their real estate investments will include less long-term rentals and more fix-and-flip syndications to reflect those short-term goals. In the end, what “diversification” means to your portfolio will be dramatically different than somebody else. Before you start diversifying, define those three determining factors.
Also keep in mind that the above-listed asset classes have their own categories and subcategories of investment types. Within real estate, for example, just some investment types include multifamily properties, apartment buildings, commercial, Airbnbs, REITs, or syndications. The more varied your assets are within class categories, the more diverse your portfolio is.
Building a Diversified Investment Portfolio
Understand where you are as an investor today. You don’t fit into a one-size-fits-all form of portfolio diversification. Here are some common questions that will help you determine your time horizon and investment goals.
- How important is cash flow to you?
- Do you have the savings to tolerate riskier investments?
- Do you have a stable household income? Do you have streams of passive income?
- How big is your income and much of it can you invest?
- Are you expecting an inheritance down the line?
- What is your cost of living?
- Are you looking to retire early?
With a clearer understanding of your needs and goals, let’s look at a number of steps you can take to build a diversified investment portfolio.
1. Diversify Across Asset Classes
We covered this one briefly already. Do your due diligence and invest in a diverse array of asset classes, like stocks or commodities, that works with your time horizon, goals, and risk tolerance. Understand that you won’t truly know if you’ll like a certain type of investment until you actually invest in it.
As a reminder, some of the primary asset classes are equities (stocks), fixed income investments (bonds), commodities, and real assets. When building your portfolio, putting all of your money in different stocks isn’t a diversified investment portfolio. Instead, a mix of asset classes is key to sustaining returns while minimizing risk.
2. Diversify Within Asset Classes
Within asset classes themselves, you’ll find that different investment types connect you to different industries, all of which trend differently. Each has their own markets, demand, and seasonality. Take commodities as an example. There are hard commodities, like steel, gold, silver, or oil, and there are soft commodities, such as agricultural goods.
Believe it or not, I have friends that invest in strawberries and corn. (You can really invest in anything, it seems.) It’s unlikely that the strawberry market and silver market are related, so having investments in both (or investing in two unlike assets within an asset class) will hedge against a market downturn in one.
3. Diversity by Location
Within the US real estate market, consider that every state, county, and city has their own unique set of circumstances that affect their market. Things like local taxes, legislation, job growth, cost of living, and many other factors play a role. Owning real estate properties in multiple cities or states can further limit risk, as a downturn in one local real estate market shouldn’t affect the market of your other property.
But this goes beyond real estate. If you invest in currency, for example, the same principles apply. Every country has different rules, taxes, and risks related to their currency, which can help you further limit risk and increase return. When one currency trends downward, your investments in other currencies protect the portfolio.
4. Explore Alternative Investments
Alternative investments are, well, alternative to traditional investments. Most successful portfolios look beyond traditional investments like stocks and bonds.
Examples of alternative investments include venture capital, hedge funds, crypto currencies, or tangible assets. Because they are unique, they tend to behave differently than typical equity and bond investments. In other words, the markets that affect stocks and bonds will be different from your alternative investments, thus lowering volatility and risk while providing broader diversification to enhance returns.
Additionally, alternative investments often have fewer US regulations associated with them. In certain circumstances, that opens up the possibility for high-yield investments that scale and skyrocket your returns.
5. Know Your Risk Tolerance
There are two major forms of risk: market risk (or systemic risk) and specific risk (or unsystematic risk).
With market risk, you are trying to measure how an overall market might be affected by various factors. Any asset type within this market will be affected, and a diverse portfolio would seek to reduce that risk by making sure to invest in multiple markets.
Specific risk is the measurement of a single company or industry-specific issue. You take on too much specific risk when you have too much allocated to a specific asset (like a single stock or bond).
How can you define your own risk tolerance? Generally, there are three types of risk tolerant investors. Those with higher risk tolerance are called “aggressive” investors. Those whose risk tolerance is in the middle-ground are called “moderate” investors. And investors who don’t want to carry much risk are called “conservative” investors. Where do you stack up?
6. Conduct Periodic Rebalancing
Your life will change dramatically over the years, and sometimes in unexpected ways. I know mine has. When I first started investing, I didn’t have kids. Back then, I was much more aggressive. Now, I’ve pulled back on that a little bit because of my evolving goals, including a financial legacy.
The same is true of markets: things change. Therefore you’ll need to periodically rebalance your portfolio diversification to mitigate changes in market volatility. What defines a market’s highs and lows today will be slightly different tomorrow, and rebalancing helps you reap rewards and lower your risk.
7. Don’t Over-Diversify
From a math perspective, there is actually a point where you could over-diversify your portfolio. And you’ll want to avoid that. Essentially what happens in this situation is that the expected earnings and returns are less than the benefit of reduced risk.
In other words, in an over-diversified portfolio, each additional investment type lowers the overall expected return rather than protects the return rate. Sometimes this can create a no-profit, no-loss situation, which is not the growth you want for your portfolio.
Frequently Asked Questions
As a beginner, where do I start with portfolio diversification?
Establish how long you want to invest first and foremost. Next, define your goals as specifically as you can, both short-term and long-term. Then determine what type of investor you are, in terms of risk tolerance, and be clear with yourself about how much you want to invest.
From there, research various asset classes and markets across industries and geographies that align with your investment goals. I would highly recommend working with a Financial Advisor that understands your goals and can help you connect the dots between your money and a diversified portfolio.
What are the four primary components of a diversified portfolio?
Traditional portfolios contain domestic stocks, international stocks, bonds, and cash.
What is the “ideal” diversified portfolio?
The answer to this question depends on you! The industry standard is a 60-40 split between stocks and fixed-income investments. The idea is that this balance creates stable and predictable returns. Of course, your splits will be determined by the variables we’ve already discussed.
But don’t forget the importance of considering your age when determining how to allocate your assets. Your financial goals will be entirely different if you just started your professional career versus nearing retirement age.
It’s Time to Diversify
If you want to meet your financial goals, it’s time to hedge against risk and maximize your returns through portfolio diversification.
That can be an overwhelming process since it has to be tailored to your unique goals and circumstances. But a support system of financial professionals and like-minded investors can act as important sounding boards while you plan actionable steps.
On that journey, consider joining one of our many communities or attending one of our exciting events to get connected with like-minded individuals looking to diversify like crazy to protect their financial future.
Thank you for reading, and I hope you take the actionable steps needed to meet your financial goals and live your dream life.
Peter Kim, MD is the founder of Passive Income MD, the creator of Passive Real Estate Academy, and offers weekly education through his Monday podcast, the Passive Income MD Podcast. Join our community at the Passive Income Doc Facebook Group.
