In the world of investing, portfolio diversification is a form of risk management. It is a strategy used whereby an investor chooses to invest in multiple assets from a range of asset classes, industries and geographic exposure to spread the risk of their investments.
These assets would be periodically reviewed and adjusted based on their past and future expected performance. The overall aim is to balance risk while investing in different sectors, themes, and asset classes.
What are the advantages of diversification?
One of the most important features of an investment portfolio is how it is diversified.
So what are the benefits of diversification?
- Diversifying your investments means you don’t put all your eggs in one basket. By investing in multiple assets, you reduce portfolio risk.
- By investing in different asset classes, you can reduce your portfolio’s volatility, and this way avoid making rash decisions based on market swings.
- Each asset usually performs differently in the short, medium, and long term. So investing in multiple assets can encourage you to make long-term investments. It may also reduce the number of times that the portfolio needs to be monitored.
- It also reduces the overall impact of market volatility, which can provide stability in times of uncertainty and bring peace of mind for the investor.
What does a diversified portfolio look like?
A diversified portfolio combines various types of investment. These include different asset types and investment vehicles that provide exposure to different themes and geographic areas and thereby limit the amount of exposure to any particular risk or asset. The idea behind holding a diverse portfolio is that by investing in a variety of different assets over time, some will bring returns. If your portfolio consists mainly of one asset or security and its value plunges, you could stand to lose a lot more than if you were holding a few different securities.
The concept of diversification is to limit risk in a portfolio. In an optimum situation, negative losses of one asset in the portfolio should be balanced by the positive performance of another asset in the same portfolio. There are several different theories on how to create the perfect diversified portfolio and it will depend on the assets you are interested in.
In simple terms, diversification is a smart move because each asset can react differently to the same event.
The question that remains is what a diversified portfolio looks like. There are several schools of thought on what constitutes a properly diversified portfolio. For example, some say that it should contain cash, bonds, stocks, mutual funds, and exchange-traded funds. Others say just bonds, cash, and stocks. Some like to include commodities such as precious metals, property, and oil.
The idea of what makes the perfect diversified portfolio has changed somewhat over the years, especially recently with the emergence of cryptocurrency and virtual currencies. The inclusion of these in diversified portfolios is likely to continue growing in popularity as the value of coins increases and adoption becomes more widespread.
What types of asset classes can be used for portfolio diversification?
As touched on above, the idea behind portfolio diversification is the inclusion of a varied asset classes list. This means investing in different assets that are part of different categories of assets and therefore have similar characteristics and adhere to the same laws. You might be wondering how many asset classes there are and what they include, here is a brief outline.
Stocks (also known as equities)
Stocks are a common component in most portfolios. Stocks represent ownership of a portion of the company and entitle the investor to a portion of the company’s profits (paid out in the form of dividends).
Fixed-income assets are interest-bearing products that pay investors fixed interest, usually at specific intervals. Government and corporate bonds are the most common types of fixed-income assets. A bond is essentially a loan given by the investor to the bond issuer, paid back to him with interest throughout the bond life.
Commodities are basic goods such as gold, oil, and sugar. Their price can fluctuate based on climate changes as well as supply and demand.
Investing in currencies involves buying one currency against selling another currency. You can trade currencies through a foreign exchange market, known as the Forex exchange market or the FX market. Trading on the FX market is done by trading currency pairs such as EUR/USD and USD/JPY.
A cryptocurrency is a digital or virtual currency, usually not issued by any central authority or government. Over the past few years, more and more investors have diversified their portfolios by investing in cryptocurrency. Examples of digital coins include Bitcoin, Ether, Litecoin, Cardano, and Tron.
How to Invest in different types of asset classes
You can invest directly in each asset type mentioned above, or via an investment instrument such as CFDs, futures, mutual funds, and ETFs.
Mutual funds are professionally managed investment portfolios made out of a pool of money collected from many investors. Mutual funds are actively managed by portfolio managers, who allocate the fund’s assets based on its objective. A mutual fund can invest in various types of securities such as stocks, bonds, and commodities.
Exchange traded funds (ETFs) are investment funds traded on the stock exchange. Traditional ETFs have a passive investment strategy where they track the performance of a specific index (such as the Nasdaq 100 index for instance). In recent years, we have seen the emergence of actively managed ETFs. The main difference between a mutual fund and an active ETF is the ability to trade the ETF intra-day on the exchange. ETFs can invest in assets such as stocks and bonds, and provide exposure to a specific theme, industry, or geographic area.
Asset allocation models to build a diversified portfolio
In terms of building your diversified portfolio, it’s not just a matter of a lucky dip or selecting assets you like the look of. There are in fact, several different models and asset allocation strategies that can be followed to create an optimum portfolio. These use predetermined criteria to build a portfolio that is both diverse, interesting to the investor, and has a chance at success.
How to minimize eToro’s Risk Score through Portfolio Diversification
A great way for beginner investors to understand the risk they are taking and that their portfolio holds is by using the eToro Risk Score feature. It is calculated using a unique formula and results in a number from 1-10 for each customer. 1 is the lowest risk while 10 is the highest. When you have created your portfolio, eToro will then assign it a risk score and display the average monthly risk score for the past 12 months. It is incredibly helpful in allowing investors to understand how investment decisions affect their portfolio’s risk levels.
These risk scores are publicly available meaning that investors can also look at the portfolios of others and use them as inspiration, or even copy them using eToro’s CopyTrading feature.
When should I consider Portfolio Rebalancing?
Portfolio rebalancing is when the investor conducts a review of the portfolio by reviewing all the assets they invested in, and how they have performed over a set period of time. Based on their assessment they will readjust the weight of each asset in their portfolio, as well as the level of exposure to each asset class. It often includes selling certain assets and buying others.
This exercise is important because it allows portfolio diversification to be fine-tuned and optimized to meet changing market conditions. Furthermore, it maintains an appropriate balance between assets and asset types.
When is the best time to do it?
There are two main theories as to when is the best time to rebalance one’s portfolio.
- The first is predetermined intervals. For example, on a set date once a year or every six months. This means that the rebalancing would occur regardless of how the portfolio is performing.
- The second option is to rebalance the portfolio when it has shifted below a certain value, or when the exposure to a certain asset is too high.
Becoming an investor doesn’t have to be complicated. Armed with the right information and tools, and through the following of tried and tested strategies, even beginners can optimize their chance at success.
These are the key takeaways of creating a diversified portfolio.
- One of the smartest investment moves you can make is diversifying your portfolio to decrease risk. This can increase opportunity, provide stability, and reduce the amount of time spent monitoring a portfolio.
- A diversified portfolio contains several asset types and investment instruments as well as a varied thematic and geographic exposure.
- These assets include equities, fixed income, commodities, cryptocurrencies, and currencies, and can be invested in directly or via ETFs and mutual funds.
- eToro’s Risk Score can be used to guide investors into understanding the risk of their portfolio. The CopyTrading feature also gives them the chance to copy the portfolio strategy of experienced traders.
- Portfolio rebalancing should be done periodically to maximize and optimize the contents of the portfolio.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.