“Don’t put all your eggs in one basket.”
It’s a common expression, but did you know it’s also valuable advice when investing? Diversification — a common strategy when building a portfolio — involves investing in a variety of assets rather than one particular asset class.
Why is a diversified portfolio so important?
There are three key reasons why diversifying is important:
A diversified portfolio helps minimize risk. Stocks can be a risky investment at any time, but with a diversified portfolio, you can help minimize the risk by spreading that risk among a variety of investments.
Diversifying can help investors maintain capital. Someone purchasing stock at the age of 30 has a much different investment goal than someone age 50. For older investors, it may be much more important to maintain capital than it is to increase capital.
You’ll have a much better chance at generating dividends if your portfolio of stocks is diversified. When one stock is performing well, chances are that another stock has dipped. By having a significant investment in both, you’ll help to offset any potential losses from underperforming stock.
It’s also common for one particular type of asset to perform better over a specific period of time, depending on external factors such as
Current interest rates
Current market conditions
But it’s also important to remember that while one investment may be outperforming others, the standard is that there is no particular investment that will continually outperform others over the long term.
But what is a diversified portfolio?
A diversified portfolio is one where investments vary, with exposure to one particular type of asset is limited. Diversifying can look like two very different things to young investors and those nearing retirement age. Young investors are much more likely to be comfortable riding out the peaks and valleys of their investment portfolio, while investors nearing retirement age are more likely to be interested in slow growth and a more consistent performance without the volatility that more risky investments may face.
In order to truly diversify your investment portfolio, many professionals recommend that your portfolio consists of the following:
Domestic Stocks. Stocks are perhaps the most volatile investment in a portfolio, but they also represent the best chance for growth. Short term investment in stocks carries the biggest risk, but stocks can also provide the biggest reward if they are held on to for a significant amount of time.
Bonds. Considered less volatile than stocks, bonds can provide a shield against market instability created by stock investments. Stocks also typically provide regular interest income. For those looking for a more significant return, high-yields bonds can be purchased, but they also carry a higher-risk.
Money Market Investments. While ultra-conservative, money market accounts and similar investments such as a short-term CD can provide stability and safety that other investment options may not.
International Stock. International stock can provide a higher return than their U.S. counterparts, but they can also carry a higher risk. However, for those looking to diversify their portfolio, international stock can be a good addition.
The key to diversification is to find the right balance between risk and stability and add accordingly, which allows you to reach your goals while also worrying less.
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