All the investments that we own constitute our investment portfolios. The portfolio is the foundation of our Financial Independence because it provides the income to sustain our lives in the future. So we need to preserve it and support its growth in value through diversification. In this post, we discuss 3 ways to diversify our portfolio.
Investment selection
The most intuitive way to diversify your portfolio is by spreading your money across many investments. I am sure that you are familiar with the concept of not having all your eggs in one basket. One way to do so is with index funds, funds that buy a very large group of securities in a specific market or sector. Index funds are cheap to own and do not require active involvement. You can have a fairly diversified portfolio with as few as 3 index funds.
Geographical diversification
Another way to diversify your portfolio is by selecting investments in multiple geographies. An important driver of our investments is the economic growth of the countries where these companies operate.
In this post, we discuss how we can invest across the entire world with index funds.
Asset classes
The third and final way to diversify your portfolio is perhaps the most important one. Diversified investors will select investments in different asset classes. For instance, if you buy a rental property you are investing in real estate; if you buy a share of Apple Inc. you are investing in stocks (public equities); if you buy a government bond you are investing in bonds.
Each asset class has its own risk-return profile.
- There are many types of risk, but if we have done a good job diversifying our portfolio across investments and geographies, the primary risk we should worry about is represented by the asset class fluctuations in value (positive and negative fluctuations).
In the long term (10 years or more), all asset classes tend to grow, but in the short term (less than 5 years) fluctuations can be quite high, especially for high risk-return profile asset classes.
So we overcome this risk by staying invested in the long term. - While the financial return is a combination of the growth in value of an asset (appreciation) and the cash that it distributes (yield). Some asset classes, such as equities, tend to have higher appreciation potential and lower yield. Other asset classes, such as bonds, have higher yields and lower appreciation. Real Estate falls somewhere in the middle. Generally speaking, the more the return of an asset class is driven by its appreciation potential, the higher is the risk-return profile of the asset class. For instance, stocks will have a higher risk-return profile than bonds.
We determine our asset class allocation as a result of the time that we have to let our portfolio grow, life goals, and our tolerance to value fluctuations. Asset allocation is perhaps the most important choice that we will ever make in our portfolio to determine our financial performance. It is more important than the individual investments that we select. Every portfolio should reflect the risk-return profile of an investor.