When it comes to investing, you know that diversification is the name of the game. That’s because a diversified portfolio can help you manage risk.
Think of it this way: You’re going on vacation to someplace warm and sunny. You pack your swimsuit, sunscreen, towels, and flip flops — everything you need for a beach getaway. But you also throw in an umbrella, some rain boots, and a sweatshirt, just in case the weather takes a turn.
A diversified portfolio is similar — it’s about having a mix of investments that can balance one another out when the market zigs or zags.
You invest in mutual funds and exchange traded funds, so you’ve got exactly what you need for a diversified portfolio. Right?
Not quite. A diversified fund and a diversified portfolio aren’t the same thing.
Mutual funds and exchange traded funds (ETFs) are examples of a diversified fund and contain stock from multiple companies (as opposed to just a single stock) and/or other holdings. Both can be a part of your investment strategy, but diversifying your portfolio goes beyond that. Here’s what you need to know.
Know your asset classes
An asset class is a grouping of investments that have similar qualities. Traditionally, there are three main asset classes: equities, fixed income, and cash.
Equities is another word for stocks. You can buy individual stocks or invest in them through mutual funds and ETFs.
Fixed income investments pay a return on a consistent basis. Bonds are the most common example of fixed income, but this asset category can also include fixed income ETFs and mutual funds.
Cash or cash equivalents are usually short-term investments that earn a fixed rate of return. Think high-yield savings accounts, CDs, or money market accounts.
Less common, but you can also invest in other asset classes like real estate, commodities, hedge funds, precious metals, and collectibles to further diversify your portfolio.
Diversify your portfolio within asset classes
The addition of different asset classes can help with portfolio diversification, but it’s important to dig even deeper as you choose which investments to buy.
Mutual funds and ETFs by themselves don’t guarantee diversification. Say, for example, you purchase a mutual fund that invests mainly in the tech sector. And you buy an ETF that’s also focused on tech companies.
The underlying assets in each fund might be different, but you’ve still tied up a chunk of your money in one industry: tech. If that sector takes a nosedive, your portfolio returns could suffer.
You also don’t want to go too niche with any one investment without understanding the risk involved. A specialized ETF that focuses on gaming tech, for instance, may be more vulnerable to volatility than a more broadly diversified ETF that includes a variety of technology companies.
It’s the same idea with stocks. Stocks can be grouped into different asset categories, based on the size of the company. For example, there are small-cap stocks (like Re/Max Holdings), mid-cap stocks (such as Whirlpool), and large-cap stocks (an obvious one: Apple).
Small-cap stocks tend to be riskier than large-cap stocks, but they have more growth potential. Mid-cap stocks land in the middle, so if you’re trying to diversify your portfolio, you may want to ensure that you have an appropriate mix of all three.
If you’re investing in real estate, diversification can mean owning a real estate investment trust (REIT) and a rental property. With cash investments, you might divide your money into a Money Market Account, a Online Savings Account, and a couple of CDs, all of which are offered by Ally Bank.
Diversifying your portfolio really requires you to take a closer look at what you own to make sure you’re not overlapping anywhere or missing out on a particular asset class.
Keep your time horizon and risk tolerance in sight
Experts tend to agree that the younger you are, the more risk you can afford to take with your portfolio. If a market downturn happens, you’ll have more time to recover from it and earn back lost returns compared to someone who’s just a few years away from retirement and might need to sell stock sooner to supplement their income.
Knowing your personal risk tolerance can help you decide what investment strategy to follow and how to manage your asset allocation for a diversified portfolio. A popular method for figuring out how much of your portfolio to commit to stocks, bonds, cash, real estate, and other investments is the rule of 110.
This rule of thumb subtracts your current age from 110. That number is the percentage of your portfolio you should invest in stocks. So if you’re 30 years old, you’d want to have a portfolio that’s 80% stocks and 20% bonds, cash, and other investments.
Ultimately, your risk tolerance is totally a personal decision. It should inform your investment strategy, which in turn, will help you create a diversified portfolio that produces the kind of returns you want for the amount of risk you’re willing to take on.
If you’d prefer a more consistent approach to diversification, a robo portfolio can help. With Ally Invest Robo Portfolios, your investments are selected for you based on your financial goals, then automatically rebalanced as the market experiences its natural ups and downs.
Whether you choose a more automated approach or prefer to DIY with your investment holdings, diversification goes beyond owning a mutual fund or ETF. It’s about having a portfolio containing a balance of asset classes that match your risk tolerance.
Build a diversified portfolio and help ensure you have (financially) sunny days ahead. Not only that, but diversification will likely make you better prepared for the rainy ones, too.
Get started building your diversified portfolio!