If you’ve been involved in or near conversation about investments, you’ve probably heard the word “diversification.” This term gets thrown around a lot, and it’s an important one to understand if you are an investor, or thinking about becoming one. A diversified portfolio is a happy one, so read on to understand how, through diversification in investing, you can create a more robust financial portfolio by spreading out your risk.
What is diversification in investing?
Diversification in investing means spreading out the risk of your portfolio across multiple different investment silos. A diversified portfolio is one in which there are many distinct buckets of investments. For example, a nicely diversified portfolio might include the following:
- Emergency fund held in cash
- Checking account
- Savings account
- Roth IRA
- One or more real estate properties
- A taxable brokerage account that has a well-defined split between equities and bonds based on investor age
I know that’s a lot. But stay with me here and I hope you’ll see that being well-diversified isn’t as difficult as it sounds.
The whole point of diversifying a portfolio is to limit the chances that one small change in the market, a job loss, or any other unknown is going to completely tank all of your investments and potential income that comes from those investments. Especially in light of recent events (hello, global pandemic), it’s more important than ever to diversify.
What is an example of diversification?
First, let’s cover an example of a non-diversified portfolio. If you have only made contributions to an employer 401K account in a single fund, you are not diversified. Since you only have one bucket of money allocated into the same fund, you are at high risk of losing money should something happen in the market to impact that fund.
The same thing goes if you bought a property that you now rent out, but you have no other investments in retirement accounts, savings, or a taxable brokerage account. If the real estate market takes a dive or you lose your tenants, your cash flow instantly goes bye-bye.
If you are in the lone 401K situation, you could diversify your portfolio by adding in contributions to a Roth IRA, taxable brokerage account, or consider looking into real estate. You can also diversify within your 401K by making sure that all of your holdings are not in the same fund. If you’re only playing the real estate game, consider keeping some money a bit more liquid in a taxable brokerage account.
What are the advantages of diversification?
One of the most prominent advantages of diversification in investing is the limitation of risk across your investment portfolio. It can be downright scary to have all of your money in a single bucket. Especially if that bucket is subject to government-imposed rules and regulations, like a retirement account.
Another advantage of diversification is that you’ll be exposed to more significant opportunities for profit. Having multiple potential investment “lines in the water,” means you have an excellent opportunity to recognize gains from a plethora of arenas. It always seems to happen that if you invest in stocks, real estate goes through the roof, and vice versa. If you diversify in both stocks and real estate, this means you now have an equal opportunity at recognizing gains for each of these areas.
How do you diversify?
Diversification in investing can be within a single investment type, or across multiple. For instance, let’s say you contribute a set amount monthly to a taxable brokerage account. Instead of going all-in on your favorite large-cap stock ETF, consider diversifying by adding in bonds, an industry-specific fund, etc. If you’re into real estate, consider buying properties located in different areas as opposed to buying several units in the same complex. With every investment you make, ask yourself questions about how you can diversify that investment, or the others in your portfolio, to eliminate as much risk as possible in the future.
How can I diversify if I don’t have that much money?
Sit down and write out your ideal portfolio. How do you want your investments to be allocated? How much would you like to have in each bucket in 5, 10, 20 years? Answering these questions can get your brain thinking about saving and visualizing the financial future you want to have.
Determine minimum investments
If you decide you want to open a taxable brokerage account, figure out with which entity, and how much you need to start. A standard number I’ve seen is $3,000, but I’m sure there are accounts out there that have lower minimums. Once you have that number in mind, start saving towards it, and once you hit it, open the account. Once you have it opened, it will be much easier to add smaller contributions over time.
If you decide to take the real estate route, determine what types of properties you might be interested in. Seek out resources that can help you understand what it truly costs to step into the real estate game.
Paula Pant at Afford Anything is one of my favorite resources for an honest look at real estate investing.
Keep moving forward
To me, investing is like rolling a ball down a hill. Once it starts to move, it picks up steam on its own. Once you open your mind to portfolio diversification and begin making changes, anything is possible. But like anything in this world, getting started is always going to be the hardest part.
Whether you are just starting or have been investing for years, it can decrease stress and increase portfolio resiliency to keep your monetary eggs in many baskets. I hope you found this information to be helpful and are thinking about ways in which you can diversify! Tell me about it in the comments.
Disclaimer: The above is my own opinion and is for informational purposes only. Views expressed above are not intended to be investment advice. While I might have some great ideas, seek a duly licensed professional for investment advice.