A 5-step guide to diversifying your portfolio
Any financial advisor will tell you to diversify your investment portfolio, but what does it mean and how do you go about it?
In a nutshell, diversifying means not putting all your eggs in the same basket. It will help you limit risk and cut your losses if a market stumbles or crashes. The opposite is also true: a diversified portfolio can ensure you reap good return on investment whenever a market grows.
Indeed, traders cannot afford to “react” to market fluctuations because by the time they do, losses have already occurred to some extent, or stocks are already too (or more) expensive to purchase. With a diversified portfolio, losses can be minimised, and gains maximised.
1. Explore different markets
The first step to building a diversified portfolio is probably to explore the different markets you can invest in, some of which are:
- Exchange Traded Funds (ETFs)
- Mutual funds
Index funds are portfolios of stocks and bonds designed to track and imitate a market index. They are a popular way of diversifying one’s portfolio because they provide broad market exposure at an affordable price. They are a popular way of diversifying your portfolio because they do not aim to “beat” the market but simply mimic it, which as a result leads to better performance than that of managed funds.
2. Lay out an asset allocation plan
A diversified portfolio isn’t a portfolio of many different investments, but a portfolio with many different types of investments. Each investment type serves a different purpose, for instance:
- Stocks or equities help grow your portfolio
- Bonds generate income
- Cash bring stability and security
- Real estate funds protect from inflation
- International securities promote growth and help maintain the market
Asset allocation is the process of dividing your portfolio into some or all of the categories listed above. How you decide to allocate your assets needs to be aligned with your financial goals, risk tolerance and investment horizon. Be sure to switch things up if any of these changes!
3. Expand your portfolio
Once you’ve outlined your allocation plan, you need to diversify again. Your stocks need to be diversified, your bonds need to be diversified, etc… This will protect you from being overly exposed if and when a market or industry struggles or crashes. Again, the key here is to avoid putting all your eggs in the same basket.
In order to diversify your assets even further, you can look into investing in different sectors and industries, companies of different sizes and locations, under and overvalued assets, etc…
Tip: buying individual stocks can turn out to be pretty expensive, as you need pay transaction fees each time. These can eat up your trading profits so should be considered carefully. When diversifying your portfolio, it could be worth looking into buying active or passive funds.
Another way of keeping things simple and cost-effective is to buy index funds, i.e. buy all the stocks of a particular index. You can also save on fees through bond index funds, international indices, real estate index funds and money market funds. You should also consider ETFs over actively managed funds.
4. Draw inspiration from
We realise that attempting to diversify your portfolio may leave you out of inspiration. Luckily there are well-known portfolios you can take inspiration from which usually fall under one of the following categories:
- Low risk
- Medium risk
- High risk
- Very high risk
Two of these portfolios are Ray Dalio’s All-Weather Portfolio and Harry Browne’s Permanent Portfolio. Both are considered “safe” because they have a track record of beating inflation and producing decent returns regardless of market cycles.
The All-Weather Portfolio was designed to make money in all market (weather) conditions by focusing on growth and inflation cycles rather than interest rates, global pandemics and political instability.
The Permanent Portfolio was designed to be simple, evenly distributed and “fail safe”. It is called “permanent” because, as Browne says, “once you set it up, you never need to rearrange the investment mix— even if your outlook for the future changes”.
To circle back to our point about asset allocation plans, this is how each portfolio allocates its assets:
- All-Weather Portfolio: 55% US bonds, 30% US stocks and 15% gold and commodities.
- Permanent Portfolio: 25% US stock market, 25% long-term bonds, 25% gold and 25% cash.
5. Review your portfolio regularly
Once you’ve completed all these steps, you might think your work is done, but not so fast! You need to review and rebalance your portfolio regularly: know when to call it quits with some of your assets and when to invest in “new” ones.
You need to make sure your investments support your financial goals, asset allocation and overall strategy. To do so, you will need to factor in your time frames and risk levels.
Rebalancing is an important aspect of ensuring that you are not overly exposed to risk and that your portfolio remains within your area of expertise. Once you are out of your depth, things can get very tricky. Therefore, you need to make sure you remain in control and on top of things once a year at the very least (depending on your time horizons).
Rebalancing is also a great opportunity to sell high and buy low depending on market fluctuations.
There are different ways of rebalancing your portfolio, depending on your overall strategy:
- Calendar rebalancing: rudimentary approach that consists in analysing a portfolio at fixed time intervals and readjusting if and when necessary.
- Constant mix strategy: a more responsive approach that focuses on recalibrating your portfolio according to your predefined asset allocation.
- Constant proportion portfolio insurance (CPPI): this (more complicated) method involves setting a floor on the value of a portfolio and structuring an asset allocation plan around this decision.
Diversifying your portfolio is a great way of minimising risk and preventing losses. It is more effective (and much safer) than simply reacting to market fluctuations. We hope these tips will be helpful to you!
Last Update on 22/06/21