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As the Little Red Riding Hood was preparing to make her trip, she contemplated the task at hand. Although there was one way to her grandma’s house, the forest was big — so making more than one trip was inconvenient. Also, she couldn’t carry a lot and insurance premiums for disobedient children were too high. So, she accepted the risk and put all the eggs in one basket.
Fortunately, when investing in the financial markets you have plenty of options. Read on to learn how to diversify your portfolio — how to reduce the risks, volatility or even increase the profits.
- 1. Use different asset classes.
- 2. Balance portfolio by sectors.
- 3. Invest in foreign markets.
- 4. Include commodities and real estate.
- 5. Research alternative opportunities.
- Benefits of Diversification
- Commissions and Fees
- Timing Your Diversification Strategy
- Mistakes to Avoid When Diversifying
- Best Brokers to Diversify your Portfolio
- Diversify in Moderation
- Frequently Asked Questions
1. Use different asset classes.
The baseline asset classes are stocks, bonds and cash. While investment professionals are able to generate returns with concentrated investing, a balance among these asset classes is the best approach for retail investors.
Although there is no clear consensus on this balance, there are 3 factors it will depend on:
- Investment goal: What is the reason for investing?
- Time horizon: How long are you planning to invest?
- Market cycle: Where are we in the market cycle?
While the first two questions are personal, the last one is harder to answer. Read more on advanced investing techniques to familiarize yourself with the market cycles.
2. Balance portfolio by sectors.
Even if you’re heavily invested in stocks (for example, early in the market cycle), you should still spread your investments over different sectors. The market divides into 11 sectors: energy, materials, industrials, consumer discretionary, consumer staples, healthcare, financials, information technology (IT), telecommunications, utilities and real estate.
Each of these sectors has a history of outperformance in certain scenarios. For example, financials do well in the high-interest rate environment, utilities and consumer staples do well in downturns, while consumer discretionary and IT do well in the bull markets.
A good portfolio will have a balance between these to reduce the market volatility. While you can go slightly overweight or underweight in certain scenarios — that has to be done research-based and in moderation.
3. Invest in foreign markets.
While researching the foreign markets was somewhat slow and sometimes inaccurate, in 2021 this is no longer the case. Staying on top of the foreign market news can be as easy as on the domestic ones.
For those who invest time in researching global affairs, geo-diversification can be a great tool to mitigate risks. Besides, foreign markets with different economic cycles can reduce the volatility of returns. For example, thanks to its exports Australia avoided recessions for almost 30 years (even the Great Recession of 2008).
Although research shows that long-only geographic diversification outperforms industry diversification, be aware of risks when investing abroad: political risk, currency risk and credit risk.
4. Include commodities and real estate.
Commodities are the oldest way of storing wealth. They are also a great way to mitigate inflationary risks. While the market is debating inflation in 2021, investing legends like Dr. Michael Burry and Warren Buffett have been raising concerns about the price of commodities and hidden inflation.
Yet, storing commodities, like operating real estate, can be an expensive venture. So, diversifying in these asset classes can be done through commodity exchange-traded funds (ETFs), real estate investment trusts (REITs) or innovative platforms like Groundfloor or Fundrise. Read more on the importance of diversifying your real estate portfolio.
5. Research alternative opportunities.
No other asset class allows you to be as creative as alternative investments. While this can be anything from baseball cards, music royalties, peer-to-peer lending, try to resist the temptation and invest in what you understand. If you like working on cars consider getting a collectible, if you used to play games like Pokémon or Magic: The Gathering — go through your old collection, as some of those cards are now worth 6 figures.
In 2021, with projects like EF Capital, it is possible to invest in online businesses. The possibilities are endless but they need to be reasonable.
Benefits of Diversification
Regardless of your goals, proper diversification can have several positive benefits to your portfolio.
- Smaller risk of ruin: There are 2 types of risk: systematic and unsystematic risk. Systematic risk is associated with the market downturn caused by an external factor. This risk is very hard to mitigate. Recent pandemic is a good example of it — when, on March 9, 2020, 499 companies in the S&P 500 index had negative performance. Unsystematic risk is avoidable — this is why it is also called diversifiable risk. By diversifying your portfolio, you reduce the chances to experience significant losses.
- Lower volatility: While volatility is the traders’ best friend, it brings uncertainty into the market. So, investors benefit from reducing it. A simple way to measure (and reduce) your portfolio is to look at the beta (β). Beta measures the individual asset move in relation to the market. As the stock market has β = 1 by default, including securities with β < 1 will reduce the volatility of your portfolio.
- Potentially higher returns: If you are not adequately diversified you might miss on growth in asset classes you do not hold. While holding the investments too concentrated is risky, holding too many is expensive, labor-intensive and diminishes the relative performance. So, meaningful diversification is one way to outperform the market benchmarks and achieve excess market returns.
- Reduced stress: Investing can be an emotional rollercoaster. Yet, if you are properly diversified you will be able to sleep more soundly — knowing that your investments have a safeguard in place.
Commissions and Fees
When investing you have to keep your eye on various commissions and fees. This will depend on your investing style, goal and time horizon. If you’re more of a trader than an investor you should consider using a zero-commission broker. These brokers got more popular in the last few years. But, if you are a low-turnover investor who just does periodical portfolio rebalancing, you might pick a full-service broker and enjoy the benefits like extra research.
Timing Your Diversification Strategy
While timing the market is a fool’s errand, timing your diversification strategy should be straightforward. After all — you should know the goal of your investing and plan its timeline.
Saving in the short term compared to the long term is often counterintuitive. You might think to take high risk for the short term and low risk for the long term but it is the other way around.
In the short term, you don’t have enough time to endure systematic (nondiversifiable risk), so for the short-term goals, your investing needs to be low risk.
Meanwhile, your long-term investing has enough time to recover for potential drawdowns. This is why a retirement portfolio can be heavily allocated in assets like equities.
The goal is to take advantage of the growth and compounding while enduring the downturns. Eventually, this portfolio will become large enough that even low-risk assets will generate significant returns for a sustainable lifestyle. If you are a beginner investor, read more on how to protect your portfolio in 2021.
Mistakes to Avoid When Diversifying
Like other investing tactics, diversifying doesn’t come without perils. Here are some of the top mistakes that you should avoid when diversifying your investments.
Not diversifying enough
The only thing worse than not being diversified is not being diversified while you think you are. Buying a few stock indexes might get you invested in hundreds of companies — but in markets with nonobvious positive correlation. You should pay close attention to how the parts of your portfolio react to market fluctuations. If they all move in one direction, you might have a problem.
The benefits of diversifying (especially in an asset class like stocks) peak pretty quickly. If you keep adding more securities with a similar risk profile, your performance will mimic that of the broad market. Overdiversification equals “diworsefication” — a term coined by a legendary mutual fund manager, Peter Lynch.
Not rebalancing your investments
Change is the only constant in the world — so, rebalancing your portfolio at some point will be inevitable. This will entail some tough decisions, but remember that money goes in your pocket only when you take the profits. A rule of thumb is to check on your portfolio at least quarterly, rebalance it at least once per year and be mindful of the market cycles.
Missing out on alternatives
Alternative investments can be a great way to diversify. This is the creative corner of investing as anything from vehicles through Lego sets to online businesses can be a good alternative. This can be an outlet for you to leverage your personal expertise, hobbies and connections.
Best Brokers to Diversify your Portfolio
The most convenient way to diversify is to control your positions on the market through brokers — regulated intermediaries that buy or sell the securities for you.
You can see the comparison of our recommended brokers in the table below.
Webull, founded in 2017, is a mobile app-based brokerage that features commission-free stock and exchange-traded fund (ETF) trading. It’s regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
Webull offers active traders technical indicators, economic calendars, ratings from research agencies, margin trading and short-selling. Webull’s trading platform is designed for intermediate and experienced traders, although beginning traders can also benefit.
Webull is widely considered one of the best Robinhood alternatives.
- Active traders
- Intermediate traders
- Advanced traders
- No account maintenance fees or software platform fees
- No charges to open and maintain an account
- Intuitive trading platform with technical and fundamental analysis tools
- Does not support trading in mutual funds, bonds or OTC stocks
Moomoo is a commission-free mobile trading app available on Apple, Google and Windows devices. A subsidiary of Futu Holdings Ltd., it’s backed by venture capital affiliates of Matrix, Sequoia, and Tencent (NASDAQ: FUTU). Securities offered by Futu Inc., regulated by the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA).
Moomoo is another great alternative for Robinhood. This is an outstanding trading platform if you want to dive deep into smart trading. It offers impressive trading tools and opportunities for both new and advanced traders, including advanced charting, pre and post-market trading, international trading, research and analysis tools, and most popular of all, free Level 2 quotes.
Get started right away by downloading Moomoo to your phone, tablet or another mobile device.
- Cost-conscious traders
- Active and Advanced traders
- Over 8,000 different stocks that can be sold short
- Access trading and quotes in pre-market (4 a.m. to 9:30 a.m. ET) and post-market hours (4 p.m. to 8 p.m. ET)
- No minimum deposit to open an account.
- No chat support
This latest groundbreaking technology is IBKR GlobalAnalyst, a new trading tool that helps investors compare the rate of PEG or price-earnings growth valuations and provide more immediate and comprehensive financial metrics of stocks, globally.
Recognizing that stock selection can be challenging for investors to compare the valuations of domestic and international stocks, Interactive Brokers created GlobalAnalyst to offer investors a simple, yet powerful tool to easily evaluate investment opportunities around the world.
Using GlobalAnalyst, investors can search for stocks by region, country, industry, market capitalization and currency to uncover undervalued stocks worldwide. The resulting table displays the current market and financial metrics, including the PEG Ratio. The PEG Ratio is the PE ratio divided by the three-year compound earnings growth rate, and smaller PEG Ratios typically indicate undervalued companies.
- Price earnings growth valuations
- Easily evaluate investment opportunities
CenterPoint Securities is ideal for active traders who demand access to advanced tools and services. While investors and casual traders are likely to be content with the basic offerings of traditional online brokerages, active traders will benefit from CenterPoint’s suite of advanced trading tools. If you value execution quality, access to short inventory, advanced trading platforms, and accessible customer service, CenterPoint is an excellent choice.
- Intermediate to Advanced traders
- High-volume traders
- Momentum traders
- Short sellers
- Unrivaled access to short inventory
- Flexible order routing for improved executions
- Discounts for active traders
- Advanced platform with fast executions
- Reliable customer service
- Not designed for beginner or low-volume traders
Diversify in Moderation
While fairy tales have happy endings, financial markets operate in reality. Its forests are deep, dark and full of predators — but also, filled with game, fruit and other riches. It is up to you to pick one of many paths that lead to your goal and stick to it.
Bringing the diversification along will have a price, yet it can be a small price to pay for peace of mind. But remember — don’t pick up more baskets than you can carry.
Frequently Asked Questions
What is the ideal portfolio mix?
Even though there are no rules set in stone for the ideal portfolio — there are 2 guidelines.
- The age rule: Subtract your age from 100 and use that number as a percentage for equities allocation. For example, if you start investing in your 20’s — stocks should be over 70% of your portfolio.
This rule emphasizes growth over stable returns, taking advantage of compounding over the years. As you get older, you will shift away from stocks into more stable, predictable investments (like bonds) as your portfolio will be large enough to provide comfortable returns while reducing risk.
- Cyclicality: While you will never know exactly when the market cycle will turn, you can have a good estimation of where the market currently is. As the market cycle matures you should be shifting away from stocks into bonds and cash. You might miss the last leg of the bull market, but when the downturn inevitably arrives you will have plenty of cash to go overweight stocks at cheap valuations.
Can a portfolio be too diversified?
The main benefits of diversification are reduced risk and volatility. But, research shows that when it comes to stocks, diminishing return starts at 20 stocks.
In relative terms, portfolio return is measured with alpha (α). It calculates the excess return in comparison to the market. If you add too many securities to your portfolio it will turn into a market index. It will be very hard to outperform the market if your portfolio closely tracks the market.