Diversity is the spice of life. But when it comes to your investment and financial holdings portfolios, it is an essential ingredient for reducing risks while maximizing the potential for growth and stability. Whether your assets are devoted to creating a comfortable situation for your retirement, or you’re more interested in short-term gains for a comfortable here-and-now, diversity is essential for hedging your bets and providing the framework for steady gains within your portfolio.

A clear understanding of asset diversification can help you accomplish more with less in your investment portfolio while reducing your risks for substantial losses if one sector of the economy or investment marketplace experiences a significant downturn.

Understanding Asset Diversification

A well-diversified portfolio has a healthy mix of asset types and investment vehicles. It isn’t simply about buying stocks from companies in different sectors. Instead, it’s about spreading your investments among many different sectors AND different investment vehicles such as:

• Stocks
• Bonds
• ETFs (exchange-traded funds)
• Commodities (precious metals, ores, oil, sugar, wheat, etc.)
• Real estate
• Currencies (cash, cryptocurrencies, etc.)

The more diversified your assets, the greater protection you can expect during downturns or shifts. If done well, the diversity within your portfolio can not only help you minimize damage when one sector of the economy experiences a downturn, but you may also experience gains in other areas to compensate for any losses you may experience.

Principles of Effective Diversification

The primary goal of diversification is to mitigate risk. Effective diversification rests on three pillars.

• Diversity of risk. It is good to have some low or no-risk investments and some that carry greater risk and offer the potential for greater rewards.
• Diversity of assets. You want to ensure diversity among asset classes and markets so that your portfolio isn’t vulnerable in one area.
• Diversity within asset classes. That includes diversity of company sizes, industries, geography, and bond maturities and risks.

Since asset diversity aims to spread your investments around so that you aren’t particularly vulnerable in one area or sector, it is something you must consistently work to do within your portfolio and not a “one and done” type of solution for investing.

Implementing Diversification Strategies

There are many different strategies you can employ for diversification within your portfolio. One of the more effective strategies is to determine how you want to allocate your assets (between stocks, bonds, ETFs, commodities, etc.) and work within each asset class to create diversity within your investments.

Another good strategy when diversifying your portfolio is to consider opposites investing so that one area may experience gains to offset losses in another area. For instance, bonds may suffer when interest rates rise, but banks and brokerage firms tend to do well during these times. Investments in both sectors mean that gains in one can offset potential losses in the other.

Diversifying Across Asset Classes

There are six major asset classes for investing. Each one carries its unique mix of risk and reward. The six asset classes are as follows:

• Stocks.
• Bonds.
• Real estate.
• Hard currencies.
• Exchange-traded funds (ETFs).
• Commodities (silver, gold, corn, wheat, cattle).

Placing all your investments, or even the bulk of your investments, in any single asset class exposes you to more significant risks when the economy experiences dips and dives. Your best bet is to spread your assets across and within these different classes.

Too many investors focus on diversity within asset classes while ignoring the greater need to diversify across the various asset classes. It exposes them to greater risk and offers sometimes painful lessons for those who fail to diversify adequately.

Portfolio Management and Rebalancing

Investors should take portfolio management and rebalancing seriously to maximize their potential rewards while minimizing risks. Financial markets are constantly shifting. Your portfolio needs to be nimble enough to respond to sudden changes in the financial markets and stable enough to weather certain financial windstorms that arrive with no warning.

While rebalancing isn’t something you need to do on a specific timeline, it is wise to do it at least once a year or more when uncertainty or volatility creeps into the financial markets, causing all sorts of upheaval.

Pitfalls to Avoid

There are many pitfalls to avoid when diversifying portfolios. Some of the critical pitfalls you’ll want to avoid in your efforts are the following:

• Analysis paralysis. Getting so caught up in exploring your options, you fail to make the investments and miss out on growth opportunities and risk mitigation.
• Getting buried in fees and fine print. Buying and selling to achieve an ideal diversity of assets can quickly accumulate massive transaction fees and brokerage commissions, ultimately damaging your holdings more than the risks they’ve mitigated.
• Eliminating risk. Reducing the risk at the cost of eliminating or greatly diminishing the potential rewards of your investments.

The other thing to consider is that asset diversity is a time-consuming process requiring some expertise. It may be worth your while to consult an expert rather than going it alone.

Takeaways

Asset diversification within your investment portfolio is essential. However, it is crucial to approach the process with a clear mind so you don’t get so caught up in the minute details of diversification that you lose sight of the purpose or the goal (maximizing the potential of your portfolio while minimizing the risk).