We’ve all heard the saying that we shouldn’t put our eggs in one basket. In the world of finance, this aphorism comes in the form of a strategy called diversification. Simply put, diversification is when you spread out your money in various investments to reduce your portfolio’s risk while increasing your overall returns.
Of course, this strategy won’t totally safeguard your assets against loss. Diversification just allows you to own multiple asset classes that may perform differently but will only have a minimal impact on your entire portfolio. A diversified portfolio may include assets like savings accounts, real estate, bonds, and even cryptocurrency such as the Monero you have in your XMR wallet.
In essence, diversification works like this: the more assets you have in your portfolio, the more resilient it will be to different kinds of risk.
Understanding Risk Types
To establish a well-planned diversification strategy, you have to understand the different kinds of risk. Investors generally work with two types of risk: undiversifiable and diversifiable. Undiversifiable risks are known as systematic or market risks caused by uncontrollable factors such as exchange rates, political instability, and inflation rates. This type of risk is not specific to any particular industry or company.
On the other hand, diversifiable risks are known as unsystematic risks which are caused by factors like financial and business risks. This type of risk is specific to an industry, company, market, country, or economy. To manage unsystematic risks, investors allocate funds to various assets so that market events won’t impact their overall financial posture.
The Importance of Diversification
Investments can change drastically in value at various times, especially for markets like crypto. As an investor, you wouldn’t want your portfolio’s success to rely on a single source. Diversification allows you to combine assets with varying risk levels to gain higher returns.
For example, you can invest in stocks, which are “high risk, high reward” assets, along with bonds that don’t offer the same level of returns but promise lower risk even when the market is down.
Planning Your Diversification Strategy
In diversifying your assets, you can do so within or across various asset classes. Diversifying across classes means that you are investing across different types of assets. Instead of investing exclusively in stocks, you could also invest in real estate or commodities like gold or silver.
In contrast, diversifying within an asset class is just spreading your investments across a single asset type. This could mean buying stocks from various companies in different industries instead of just one particular niche or putting everything on a single company.
There isn’t a secret sauce for determining how diversified a portfolio must be, but a good heuristic is to invest in disparate assets with returns that do not correlate with each other. Regularly investing at certain periods rather than in one go can also mitigate the impact of market fluctuation. You can try investing in the following to get started:
You may have already known that stocks have the highest potential for big returns despite short-term market fluctuations. You can also try investing in international stocks to gain exposure to other markets with different economic cycles, but doing so can be expensive. Opting for a managed fund is a more cost-effective way to start participating in international markets.
Like the stock market, the crypto market also requires an aggressive risk appetite. Investing in crypto could lead to massive gains, with the added bonus of blockchain security. You can also “mine” crypto, which is essentially getting crypto for free.
But of course, crypto is still on unpredictable grounds and can lead to either scams or huge losses, especially for the uninitiated. It’s still important not to put too much on crypto assets and limit their share of your investment pie.
Bonds provide steady returns and fixed payouts, even with potential changes in interest rates that can impact your gains. Because they are less volatile than stocks, bonds can serve as your regular passive income as well as a cushion for the unpredictability of the stock and crypto markets. You can also invest in high-yield and international bonds that offer higher returns, albeit a higher degree of risk.
If you have no time to diversify your portfolio, you can invest in asset allocation funds, which are basically managed funds that help you spread your financial assets. You can also invest in sector funds, which focus on a single economic segment, or a commodity-focused fund that caters to industries like mining, oil and gas, and other natural resources.
Another great place to put your assets is in real estate or real estate investment trusts (REITs). Real estate assets can appreciate over time and lead to higher gains, but maintenance and commission fees can also be costly.
Certificates of deposit (CDs), money market funds, and savings accounts are also forms of investments that are intended for a more conservative risk appetite. These investments can grow steadily depending on interest rates and other binding terms.
A Safety Cushion, But Not Without Risk
Diversification is a good risk-management strategy that can help minimize the volatility of asset prices. However, diversifying does not completely guarantee financial safety. Market conditions can still impact your portfolio, no matter how diversified it is. In the end, the key to a well-diversified portfolio is finding that happy medium on the spectrum of risk and return.