Aug 11, 2022
How To Diversify Investments: A Beginner’s Guide for 2023
Navigating the stock market will always come with risks. But a well-diversified portfolio is one of your best defenses against market downturns or financial crises—not to mention a cornerstone of building long-term wealth.
Still, as a beginner investor, you might be wondering how to diversify investments in the first place. That’s where this guide comes into overview eight essential steps.
In this article, we’ll cover how to:
- Understand asset classes
- Diversify by asset class
- Diversify within asset classes
- Invest in an index fund
- Consider fixed-income investments
- Follow a buy-hold strategy
- Keep investing over time
- Regularly rebalance your portfolio
Read along to learn how to diversify your investments.
What is diversification, and why does it matter?
Diversification means spreading your investment portfolio across different types of assets to reduce overall risk.
You’ve likely heard the saying, “Don’t put all your eggs in one basket.” Turns out, this age-old saying ties precisely to the purpose of diversification—that is, to avoid investing all you have into one area of the stock market.
By splitting your portfolio across different assets that behave differently in the market, you reduce your vulnerability to the risks tied to any single asset. That’s because the negative performance of one asset can be offset by the positive performance of another, potentially yielding higher returns and more stability overall.
How to diversify your portfolio: 8 strategies
There are a variety of strategies available when it comes to diversifying your investments, but the steps below are a great starting point.
1. Understand asset classes
If eggs represent your money, baskets represent the various asset classes. Asset classes are simply different types of investments, like stocks, bonds, or commodities. Investments with similar characteristics that behave comparably in the market are grouped within the same class.
Building a well-diversified portfolio starts with choosing a broad mix of investments. Here are the major asset classes:
- Equities (stocks): allow investors to have partial ownership in a company
- Fixed-income securities (bonds): securities where investors lend money to a company or a government in exchange for regular interest payments
- Cash: investments or accounts that are liquid and readily accessible (short-term certificates of deposit, money market accounts, checking and savings accounts)
- Alternative investments: investments with a generally lower correlation to the stock market (real estate, commodities, hedge funds)
The risks associated with each asset class are different, as are the returns each one can provide. If your goal is to minimize risk and maximize returns, you should be investing in a variety of asset classes. When your portfolio has a healthy level of diversity across asset classes, one asset’s poor performance can be offset by the stronger performance of a different asset, potentially reducing overall risk over time.
2. Diversify by asset class
Generally speaking, stocks represent a higher risk and higher returns, while bonds offer less risk and lower returns.
Knowing your investment time horizon—the length of time you plan to hold your investments for—is important in determining which asset classes to invest in. Younger investors with a longer time horizon can stand to take on riskier investments like stocks, whereas those with a shorter horizon might choose a higher allocation of more stable investments like bonds.
|Investor tip: A helpful way to find your ideal allocation between stocks and bonds is to subtract your age from 100. This number is the percentage you might allocate toward stocks—for example, a 27-year-old might invest 73% of their funds in stocks and the remaining 27% in bonds.|
3. Diversify within asset classes
Once you’ve diversified across asset classes, the next strategy is to further diversify within those asset classes. One way to do this is to invest in a wide range of companies across different sectors, which can protect you in the event that one sector takes a hit.
For example, if you invested solely in technology companies and tech spending suddenly declines during a market downturn, all the shares you bought in those companies might decline at the same time. Instead, spread your dollars across companies from different industries, sectors, and regions.
When choosing the specific companies you want to invest in, it’s important to do some research upfront to determine the stability and earning potential of the stock.
Consider the following when evaluating what companies to invest in:
- History of profitability and dependable earnings: use the SEC’s Electronic Data Gathering, Analysis and Retrieval (EDGAR) to pull companies’ annual financial reports. Look for Form 10-K to view balance sheets, sources of income, revenues, and expenses, and Form 10-Q for a quarterly update on operations and financial performance.
- Reputation: do they contribute to any philanthropic efforts? Are they well regarded by the public?
- Reliable senior management team: learn about management by reading annual reports, press releases, and researching the board of directors. Are they mainly company insiders, or is there a diversity of independent thinkers in the mix?
- Dependable products and services: are their products and services something you believe in yourself? How strong is consumer appeal? How well do you understand what they’re selling?
Purchasing shares in different companies and sectors is one of the quickest routes to diversification. However, you’ll need to invest in more than just three or four individual stocks to build a truly diversified portfolio. Beginner investors can benefit from investing in at least 12 to start, then building up from there. Keep your total number of different stocks at around 25 to keep things manageable.
4. Invest in an ETF
If you don’t have time to research individual stocks, you might consider adding passively-managed funds to your portfolio, such as exchange-traded funds (ETFs). An ETF is a basket of securities that can track specific sectors, segments of the market, or the entire market. When you buy an ETF, you’re buying the entire pool of securities within that fund, giving you broader exposure compared to a single stock. You can browse ETFs available on Stash and filter by risk level to find the right ETF for you.
Adding even a single ETF to your portfolio can significantly diversify your asset mix—and they tend to have lower fees compared to, say, a mutual fund.
5. Consider fixed-income investments
You may also want to invest in additional fixed-income assets like bonds. While bonds see lower returns than stocks, they help balance the overall risk profile of your portfolio, further protecting you from market volatility. To diversify your bonds, choose bonds with different credit qualities, maturities, and issuers (the U.S. Treasury, municipal bonds, corporates, etc.).
If hand-selecting the right bonds feels daunting, you can still expose your portfolio to fixed-income investments with a bond-focused exchange-traded fund (ETF) or mutual fund. While bonds have a lower annual rate of return, they’re a reliable defense against an unpredictable market.
6. Follow a buy-hold strategy
Your portfolio goes hand in hand with your long-term savings goals. To get the most out of your investments, keep a long-term mindset when diversifying your portfolio—especially during times of market volatility. A buy-hold strategy will serve you more in the long run than being reactive to the market or constantly making trades, and is key to a more stable portfolio. Don’t be afraid to give your investments enough time to grow.
7. Keep investing over time
Adding to your investments on a regular basis is a great way to build up your portfolio. If you only have a small amount of money to invest, you might consider a systematic investment plan (SIP) like Stash’s Recurring Transactions. SIPs allow you to invest small amounts in mutual funds periodically instead of investing a single lump sum, making it ideal for those who don’t have a large sum of funds available but can afford to invest a small portion each month.
Since the amount can be auto-drafted from your bank account each month, SIPs are also a great tool to develop more disciplined investing and financial habits—especially if you’re new to regularly putting money aside to reach long-term goals.
8. Regularly rebalance your portfolio
Once you have your ideal asset mix, commit to maintaining it with regular checkups and rebalancing. Investing is an ongoing process that requires intentional readjustments along the way.
To ensure your portfolio stays current, regularly review the performance of your investments and check on the balance of each of your assets. Your periodic review should be done with your original goals in mind—it’s helpful to compare where you started with where you are now, and determine if things are moving in the direction of your long-term goals. Then, assess if your portfolio is still within the risk level you’re comfortable with. If not, rebalance any assets that have drifted as a result of market performance.
If you’re an investor with less time or energy to dedicate to your portfolio, relying on a robo-advisor can automate this step for you. Robo-advisors, like Smart Portfolio, will automatically rebalance your investment portfolio based on your risk tolerance so you don’t have to.
3 Diversified portfolio examples
Now that you know how to diversify investments, you might be wondering “what does a diversified portfolio look like?”
Those with a more conservative risk profile typically allocate a higher percentage of funds toward bonds, while those aiming for more aggressive growth over a longer period of time often allocate more funds toward stocks.
For more perspective, here are a few portfolio examples illustrating various asset mixes depending on different goals and time horizons:
- 20% stocks
- 50% bonds
- 30% short-term investments
- 50% stocks
- 40% bonds
- 10% short-term investments
- 70% stocks
- 25% bonds
- 5% short-term investments
No matter your investment portfolio preference, remember that investing is best approached with a long-term mindset if you hope to build wealth and financial security for the future, and diversifying your portfolio is a fruitful way to get there. Ultimately, learning how to diversify investments is a matter of balancing risk and reward—by choosing the right mix of investments, you’re giving your money the best possible chance to grow and compound over time.
If you’re looking for a little more support, consider turning to a platform like Stash. We make it easy to invest what you can afford on a set schedule, all while providing unlimited financial education and monitoring your portfolio’s diversification.
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FAQs about how to diversify investments
Have more questions about how to diversify investments? We have answers.
Is it possible to over-diversify your portfolio?
Yes. Over-diversification occurs when additional assets added to your portfolio lower the overall expected returns without also reducing the associated risk profile. In this instance, the additional assets aren’t serving the purpose of diversification.
What are alternative investments?
Alternative investments are assets that don’t fall into one of the main asset classes (stocks, bonds, and cash). Alternative investments can include private equity, hedge funds, art and antiques, commodities, tangible assets, cryptocurrencies and real estate, to name a few.
They’re deemed “alternative” due to their lack of regulation and difficulty in determining their value. However, since they often have a low correlation to the performance of stock and bond markets, they tend to maintain their value during times of market downturn, making them a suitable diversification tool.
How is portfolio risk measured?
The most common measure of risk is standard deviation, a statistical measure of the volatility of investments relative to return disparity. In other words, it measures the spread of returns relative to the average return. The higher the standard deviation, the riskier the investment.
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