We all aim to invest in what will become the best-performing asset class each year, but the unpredictable nature of markets makes this incredibly challenging. US large caps might dominate one year and then lag the next. Cash might take the top spot and then be the worst-performing asset for the next several years. Most of us just aren’t savvy enough to consistently pick the winners. That’s why diversification is important.
A well-diversified portfolio can mitigate market fluctuations, reducing the risk of significant losses. However, it’s crucial to strike a balance, as an over-diversified portfolio can become hard to manage and may lead to diminished returns.
Here are five considerations when building a diversified portfolio from scratch to effectively manage risk and optimize returns.
Diversification is a fundamental principle in investing that involves spreading your investments across various asset classes, sectors and geographies to reduce risk and enhance potential returns. In essence, it means not putting all your eggs in one basket, ensuring that a downturn in one area doesn’t devastate your entire portfolio.
Diversification also allows investors to benefit from different opportunities and market conditions, potentially leading to better overall returns.
Setting clear investment goals, assessing your risk tolerance and determining your investment horizon are critical first steps in financial planning. Once you know what you’re aiming for, your acceptable risk levels and the amount of time you plan to hold your investments, diversification becomes a powerful tool to help you reach those goals.
While diversification doesn’t guarantee success, it’s a strategic approach to building a resilient portfolio that can withstand market fluctuations. This can help you achieve your short- and long-term financial goals with more confidence.
According to the American Association of Individual Investors’ Asset Allocation Survey, in May, stocks comprised 70.39% of investors’ portfolios, bonds 13.77% and cash 15.83%.
Traditionally, stocks, bonds and cash have been the main asset classes:
Investment professionals often recommend going beyond these basics, including alternative assets like real estate, commodities and cryptocurrency. Different asset classes generally have low correlation with each other. So, if one is underperforming, others may yield positive returns, helping to hedge against losses.
Optimal asset allocation varies per individual and is influenced by factors such as age, financial goals and risk tolerance. Historically, a balanced portfolio of 60% stocks and 40% bonds was considered optimal, but this has evolved since the Covid-19 pandemic. Experts like Goldman Sachs now suggest that correlations between stocks and bonds have increased, making the traditional 60/40 split potentially riskier.
Investing across various asset classes is just the beginning. Market performance can shift your investments out of alignment with your original goals, requiring regular rebalancing. Rebalancing involves adjusting your portfolio to maintain your target asset allocation, ensuring you stay on track with your investment strategy.
Unfortunately, many investors neglect this. A CNBC survey revealed that one in four Americans are unsure if their investments are diversified, and 42% don’t actively monitor their portfolios.
Regularly reviewing and rebalancing your portfolio can help you manage risk and stay aligned with your financial goals.
Your choice of investment platform is crucial, as it provides the infrastructure and tools necessary to manage and allocate investments across various asset classes.
The best brokerage accounts offer access to a wide range of options, including stocks, bonds, mutual funds and exchange-traded funds (ETFs), which are essential for diversification. An increasing number of brokers are also now offering access to alternative investments, giving investors exposure to unique asset classes with low correlation to traditional investments like stocks and bonds.
Moreover, investment platforms often offer features like portfolio analysis and risk assessment, which help investors maintain their desired asset allocation over time. Additionally, robo-advisors can offer automated rebalancing, making it easier to keep your portfolio on track with minimal effort.
A well-diversified portfolio can protect you from market volatility and reduce the risk of significant losses, but it’s essential to avoid common pitfalls:
Building a diversified portfolio is about balance and strategy. Start with clear goals, spread your investments across various asset classes, regularly rebalance and stay informed about your portfolio’s investments. Avoid common mistakes like overconcentration and overdiversification, and choose an investment platform that offers the necessary tools and investment options for effective diversification.
Remember, the goal is to build a portfolio that can withstand market fluctuations while helping you achieve your financial goals over time. Is your portfolio diversified? Take the quiz.
Matt Miczulski is an investments editor at Finder. Matt dissects and reviews brokers and investing platforms to expose perks and pain points, explores investment products and concepts and covers market news, making investing more accessible and helping readers to make informed financial decisions.
Before joining Finder in 2021, Matt covered everything from finance news and banking to debt and travel for FinanceBuzz. His expertise and analysis on investing and other financial topics has been featured on CBS, MSN, Best Company and Consolidated Credit, among others. Matt holds a BA in history from William Paterson University.
This article originally appeared on Finder.com and was syndicated by MediaFeed.org.
Image: Pexels
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