Portfolio Diversification: One of the Oldest Adages in Investing
Historically, a thoughtful allocation of assets in a diversified portfolio has proven to be a solid tool for managing the risks and rewards of investing.
Updated June 28, 2022 • 3 min read
Allocating assets to diversify a portfolio is arguably the foremost pillar of investing. It involves balancing risk versus reward by owning varying percentages of different assets. In most cases, this balancing process involves translating your financial circumstances, objectives, and constraints into a bucket of assets — a portfolio — to achieve your financial goals in conjunction with your tolerance for risk. Creating a balanced portfolio requires that you choose specific investment products (stocks, bonds, commodities, real estate, cryptos) to generate passive returns and protect against market volatility.
What Is Asset Allocation?
Asset allocation, also referred to as diversification, is a critical part of any investment strategy. Personal considerations like your risk tolerance level, financial goals (do you want to make quick cash, save for your child’s college tuition, or buy a house?), and investment time horizon help determine how you choose the assets in your portfolio. Owning a mix of stocks (equities), bonds (fixed-income), and cryptocurrencies can help generate passive income and simultaneously protect against market downturns. Many new investors, however, can find the process of market diversification daunting. If you’re among them, rest assured that there’s help available, both in the form of financial advisors, as well as index funds, which can provide you with immediate portfolio diversification (a mix of stocks or other securities) and less risk, generally for a low price.
Why Should We Practice Diversification?
The reason we diversify our holdings is to protect ourselves from market turmoil. Different investment instruments tend to perform differently depending on what’s happening in the market. So owning a variety of assets means that when some lose value, others may gain value. It’s also possible for all assets to increase in value or all assets to decrease in value. But the point of portfolio diversification is to avoid diminishing returns across the board. Historically, when stock prices are rising, bond prices are falling on lower demand. Conversely, when stock prices drop — and investors seek the lower risk (but lower return) of fixed-income instruments — then demand for fixed-income products (like bonds) increases, and in turn, so do their prices.
It’s critical to note that even though a diversified and well-allocated portfolio seeks to mitigate risk, the goal is still to optimize monetary gain. The mantra is to maximize returns while minimizing risk. A well-diversified portfolio usually includes a mixture of stocks, fixed income, and commodities, like gold and oil. In today’s market, a diversified portfolio may also include one or more crypto assets, and those cryptocurrencies and crypto tokens should also be diversified.
Examples of a Diversification Strategy
Market diversification should occur at multiple levels: both between asset classes and within asset classes. To attain adequate portfolio diversification you’ll likely need a mix of stocks, bonds, commodities, crypto, and more, but within those categories you also may want to diversify further. For example, in the category of stocks, you could purchase technology stocks, telecommunications stocks, consumer products, energy, and so on.
For cryptocurrency diversification, you could hold bitcoin (BTC), ethereum (ETH), and litecoin (LTC), each of which may perform differently under different circumstances. If you’re deeply knowledgeable about crypto, there might be various other coins you would choose to hold as well. In all cases, crypto or otherwise, the goal of asset allocation and portfolio diversification is to find investment opportunities that are uncorrelated — that is, the price movement of one asset has no impact on the price movement of another asset, and therefore will perform differently under different market conditions.
Not Just For Hedging
Portfolio diversification is not only a hedging method; it can also boost your returns should some of your investments take off and grow many times over. When it comes to cryptocurrencies and tokens, the more you are invested in, the more likely it is that one of your cryptos will succeed. Although, of course, you need to front more cash to purchase more of these digital assets. And, it’s important to remember that cryptocurrency diversification may still lead to financial loss.
Easy Ways to Diversify
Portfolio diversification is complicated, and many people simply lack the time to do it on their own. Brokers and institutional investors know this, and have created a number of products to provide individual investors with diversity without having to do the legwork. Products like mutual funds and exchange traded funds (ETFs) follow well-known predetermined benchmark indexes like the S&P 500 or the Russell 3000 to give investors exposure to the many hundreds, if not thousands, of companies in those indexes. While there are no cryptocurrency ETFs currently available to most investors, work is underway between cryptocurrency businesses and regulators to bring this product to market to offer more efficient and effective cryptocurrency diversification.
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