7 tips to have a diversified investment portfolio
One of the best ways to understand how investing works is to study the differences between various kinds of investment vehicles and to compare how those vehicles produce value. Many investors, for example, are confused by different kinds of bonds. Some investors don't know for sure exactly what a bond is or how one works. With the details of basic investing as confusing as they can sometimes be, it shouldn't be surprising that advanced topics like diversification, strategies or allocations are as well.
The good news is investing is very much like any other activity. The more you study and practice, the better you get. Like sports, investing is built on a foundation of basic fundamentals which have been proven over time to produce the best results for the largest plurality of participants. Learning those fundamentals is the best way someone new to the market can gain the highest level of proficiency the fastest while avoiding the pitfalls new investors face.
So what is the best way for a new investor to be certain they are diversified?
It is axiomatic that some investments perform well when others lose ground. The best example of this is when one investor shorts a stock and another goes long. One expects prices to rise in order to secure gains while the other is betting the price will drop so they can return borrowed shares at a profit. While it doesn't make sense to buy and short the same stock, it does make sense if heterogeneous investments can be offset against one another in order to protect against adverse market moves.
One of the best examples of a hedge is buying a hard asset like gold to offset potential losses from inflation. As most investors know, your gains must exceed inflation and taxes or you are losing value. The value of gold often tracks closely the value of whatever currency in which it is priced, meaning that if inflation rises, the price of gold will often follow.
In this case, even if an investor's stocks lose value from that inflation, their gold position will help offset those losses, leaving them in position to take advantage of later gains in the stock price without having to make up for the virtual losses instead.
Income vs. Growth
The time horizon for an investor usually governs their allocations of income and growth investments. Early in a portfolio's existence, growth is the priority, as it is important to produce wealth before it can be exploited. This means a new investor should buy heavily in growth vehicles like small cap stocks. Some financial advisors recommend at least 80% of a portfolio be invested in growth stocks and similar investments to start.
Later in an investor's career, as their wealth accumulates, their proportion of growth investments to income investments should begin to shift. Income investments include bonds, annuities, bond funds, certificates of deposit, dividend stocks and money market funds. These are investments that usually maintain their price but throw off regular payments to the investor. A bond, for example, is paid for by the borrower in the form of interest and sometimes a small portion of principal.
Income investments are only tangentially affected by ups or downs in the overall market, and represent a much larger pool of capital than stocks in general. Because of this, investors looking for a way to diversify will very often offset their stock and growth investments with income-producing vehicles like bonds. This way, even if they have adverse price changes in their stocks, the income from their bonds and other income-producing investments is likely to offset them.
Like income investments, cash can act as a hedge against changes in the market. Cash is key to any investment strategy that relies on timing the market. While some brokers and financial advisors recommend investors avoid moving in and out of investments too often, sometimes it can be lucrative, especially in various kinds of distressed debt strategies.
Cash should be set aside in a vehicle like a money market fund where it can be accessed immediately. This is also known as a "liquid" investment. Money market funds are minimal income investments, so they can be used to diversify against an equity-heavy portfolio.
Investments like government and municipal bonds should be considered for any portfolio that needs income. Some of these kinds of bonds generate tax free revenue. They can be used not only to hedge against equities, but they can also be used to offset potential losses in commercial paper like corporate bonds or capital for partnerships and start-up enterprises.
On the equity side, the equivalent to matching tax-advantaged government bonds with commercial paper like corporate bonds is to invest in different sectors of the stock market. One way to do this is by spreading equity positions between large and small companies. Another way is to invest in different industries like mining, technology, health care and construction.
With the exception of equity investments in the construction industry, real estate can act as a hedge in your portfolio very much like gold and other hard asset investments. Like gold, real estate tends to appreciate in an inflationary environment, and it can also throw off income in the form of rents and leases. Real estate investors could be described as Pumped on Property and well they should be.
Unlike other kinds of investments, real estate requires considerable management time, so make certain you have the extra capacity to manage your properties before you make any expensive moves.
As your wealth grows, you'll find some opportunities will present themselves that don't fit neatly into other categories. Entrepreneurs may approach you for relatively small amounts and may offer you equity positions in their start-up companies. Some of these companies may have developed valuable assets like patents or copyrights in the process of getting started. Some may even have considerable sales already. These investments are extremely high risk, naturally, but they can also produce outsized returns. Treat them like small cap equity positions and hedge accordingly, and you may find a diamond or two in the rough.
Diversifying is essentially the process of protecting one investment with the income from another. While it might seem that you are trying to avoid losses in your equity portfolio, the truth is your equity positions are hedges against your bonds and income investments. Properly managed, the offseting advantages should lead to success.