The Importance of Diversification

You’re only allowed to pick two items from tonight’s dinner menu. And tomorrow, the same two items. Every night. Can you imagine?

Limiting your food options is as dangerous to your physical health as limiting your portfolio is to your financial health. Weird analogy but true.

Just as you manage your lifestyle choices, you also manage your portfolio. It’s paramount that you school yourself on the importance of diversification. Sure, you probably hold several decent-paying stocks, and you dream about the day all of them shoot skyward. Sometimes, you get lucky—but sometimes, you inevitably lose money.

Diversification is never more important than at that moment. Having several investments across industries and investment types, you can help offset your losses in the event the market tanks. You know what they say about eggs and baskets.

What is diversification?

Diversification of your portfolio is an approach designed to reduce your risk and enhance or bolster your rate of return by allocating amounts to various types of investment opportunities. Diversification can help you avoid stunning losses and stabilize your performance.

What asset categories should be in your portfolio?

Investments are valued based on several factors, but they’re basically divided into three main groups:

  • Investment vehicles such as stocks and bonds. This can also include alternative investments, such as real estate or land. The value of these investments typically flows with the market it belongs to.
  • Supply and demand. This includes such investments as oil, gas, and other commodities, natural or otherwise. The value of these types of investments is typically affected by political events in a specific geographic location or by regulations introduced in that location or region.
  • Store of value. These investments tend to include such items as vintage automobiles, art pieces, gold, and other precious metals. The value of these types of investments is defined by what the investor, or collector, is willing to pay.

How can diversification boost your return rate?

Proper portfolio diversification is a personal choice, but it’s best to invest in several different types of investments, including alternative investments and different asset classes. It also doesn’t hurt to invest in other regions. This offers exposure to the whole universe of investments.

For instance, say you decide to diversify by investing in several sectors in a certain geographical region—such as Saudi Arabia or Iran. Your portfolio might be diverse, but overall, you’re only exposing your portfolio to one country’s economy, a single currency, and just one commodity, more or less. In this case, that commodity is oil. Your average return rate might hover around 5%. Not bad.

If you were to take just half of what you initially invested and invested instead in an international ETF (Exchange-Traded Fund), you might see a return closer to 6% thanks to the further diversification of asset types and geographical regions.

But again, diversification is key—while the examples above show the benefits of diversifying, there are still more horizons you could chase. Say you take one-third of that initial investment and put it into alternative, illiquid investments. You might see an even greater return closer to 10% because you’ve now added an investment type that doesn’t fluctuate with the whims of the overall market.

It’s important to spread your investments across multiple asset classes, types, and even regions—think real estate in various states—to truly experience the benefits of diversification.

So, what does it look like in practice?

How to maintain portfolio diversification

While any type of investment carries risk, diversifying your portfolio helps mitigate the sudden market fluctuations and protects you from undue risks. Proper diversification requires you to:

  • Vary the asset class. Put some money into stocks, some into bonds or mutual funds, some into an ETF, and some into real estate, for example.
  • Vary the type or subclass of each asset class. For instance, if you decide to invest in stocks, diversify your portfolio between growth stocks and value stocks.
  • Vary the sectors. Really feeling that Tesla stock? Or maybe you love Apple. Tech stocks are fantastic investments, but it’s important to diversify and include investments from multiple sectors, such as energy and healthcare.

Diversification certainly offers ample options. So, how do you know when you’ve diversified enough? Or too much?

If you’re new to investing, finding that sweet spot—the investor’s Goldilocks zone—can be as simple as investing in an index fund that mirrors the S&P 500. As you learn the ropes, you can add an index fund or two with different levels of risk. Consider index funds that:

  • Buy shares of companies in different geographic areas
  • Have shares in smaller growth companies
  • Buy bonds
  • Have shares in various real estate investment trusts, or REITs

Did you know? With Ark7, you can buy shares of actual properties. Learn more.

Every type of investment’s performance can vary greatly depending on market conditions. If you have a diversified portfolio, it’s much more likely it’ll have well-performing investments at any point in time.

Allocating assets

Asset allocation is one of the most popular forms of diversification. By having multiple representations of varying classes of investments, you mitigate the risks associated with having all your eggs in that proverbial basket. Plus, you help your portfolio maintain its value.

For instance, say stocks start to plummet, but other investments begin to soar because savvy investors are moving the money they had in stocks to investments with less risk. To illustrate, if your portfolio has stocks, an ETF, and a REIT and the stock market crashed, you wouldn’t be entirely out of luck—not like someone whose portfolio was solely made of stocks. Your investments might not earn returns as quickly as stocks sometimes do, but it means you’re protected from huge losses.

Choosing different asset classes

While it’s good practice to have varied assets in your portfolio, it’s also a good idea to further diversify with each asset class. Remember back at the turn of the millennium when investors couldn’t get enough tech stocks? Their shirts were torn from their backs as that dot-com bubble popped, leading to a rapid sell-off of tech shares. Subprime mortgages did the same thing to finance stocks near the end of 2007 and the beginning of 2008.

Real estate crowdfunding for diversification

To talk about food again—say, you’re having your friends over for pizza. You all pitch in for the pie knowing you’ll all get at least one slice. If someone ends up not all that hungry, the rest of you can split up the leftover pieces.

Real estate crowdfunding is kind of like sharing a pizza with your buds. It brings multiple investors together to jointly invest in properties that are, for instance, already rented in the hopes of splitting a piece of the rental income pie. The investors become co-owners of the property, each with less of an investment than if one investor were to buy the entire property alone—and less investment means less risk.

This type of alternative investment is much more liquid than buying an entire investment property alone and can provide solid returns over the life of the investment.

Finding the Goldilocks zone

Diversification, just like investments in general, is a personal decision. How much diversification your portfolio should have depends on a variety of factors, such as your financial goals and your personal risk tolerance. There isn’t a perfect balance. Your “perfect” diversification is unique to you and your financial situation. The only wrong move you can really make is over-diversification—investing in so many different areas that no one area has enough investment to really make a difference.

While you should come up with a schedule for adding additional investments, you shouldn’t add a new investment just for the sake of doing so. Buying and holding too many different assets can make tracking and managing your funds more difficult. The whole point of diversifying is to make managing your risks easier so you can earn sufficient returns.

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