What is diversification?
Diversification refers to an asset allocation plan for trading, consisting of properly allocated assets across different types of investments. Investors who diversify their portfolio are accepting a certain level of risk and thus need an exit strategy if something goes wrong.
Traders can reduce a large part of their risk if they diversify their investments over a variety of assets. The asset allocation helps to distribute the risk as different investments tend to rise and fall independently. The aim is to achieve a balanced, diversified portfolio containing a combination of investments that would cancel out each other’s fluctuations, reducing the risk in the process.
Here Are 5 Valuable Diversification Tips for Your Stock Portfolio:
- Building One’s Portfolio: Traders should regularly add on to their investments to help smooth out the peaks and valleys created by market volatility.
- Knowing When to Exit: Traders should constantly be updated about any changes in their investments related to changing market conditions. By being aware of what companies to invest in, traders can also instinctively realize when to cut their losses, sell and move on to their next opportunity.
- Considering Index or Bond Funds: Traders may consider adding fixed-income funds or index funds to their portfolio.
- Spreading the Wealth: Traders should never invest all their money in one stock or industry. They can instead create their own virtual mutual fund by investing in a variety of different companies.
- Understanding Commissions: Traders should always understand what they are getting for the fees they are paying. It can eat away at a trader’s profit if the fee structure is expensive.
Various Returns and Risks
When diversifying one’s portfolio, traders and investors always consider spreading their investment across multiple asset classes after determining what percentage of the portfolio should be allocated to them.
These include the following asset classes:
- Bonds, which are conservative corporate and government fixed-income debt instruments.
- Stocks, which are shares or equity in any publicly traded company.
- Exchange Traded Funds or ETFs, which are a basket of securities that follow a particular sector, commodity, or index.
- Real-estate includes Commercial and Private buildings, land, real estate investment trusts, natural resources, livestock, agriculture, water and mineral deposits, etc.
- Cash and short-term equivalents, such as treasury bills, money market vehicles, certificates of deposit, as well as other low risk, short-term investments.
- Commodities, which include the goods necessary for the production of other products.
Traders should always pick investments with different rates of return and risk. It is thus essential for traders to include stocks with mixed-income, market capitalization, and growth. Here, investing in “Blue chips”, which are nationally recognized and financially sound companies, can help.
Ultimately, the stock trader’s diversified portfolio should include both volatile as well as conservative consumer stocks to balance out the risk and create a balanced source of potential profits.
Search for different industries and widen your portfolio geography
Industry diversification is considered as one of the diversification strategies used by traders where they choose investments from different fields. This is done for avoiding unnecessary losses due to a single industry performing poorly, which in turn minimizes the overall portfolio risk. The benefits of diversification increase, as the correlations of stock returns in different industries seldom move in the same direction at the same time. Business cycles should be considered when selecting industries in which to invest. Industries sensitive to business cycles experience more fluctuations in stock prices. For instance, the food, healthcare, and energy industries are not sensitive to business cycles, while industries such as technology, oil, finance are sensitive.
Traders should thus consider diversifying their portfolio by investing in varied industries such as buying tech stocks, stocks of retailers, oil stocks, etc, canceling out each other’s risk. A trader’s portfolio is thus protected from losses that can occur due to any single industry taking a nosedive.
Another good way to diversify is to spread one’s investment across different countries through foreign stocks. This is because stocks from other countries are affected differently by national policies and thus, balance out the other domestic stock elements in the portfolio. Both geographical and industry diversification is ideal for strengthening a trader’s portfolio.
Defensive Assets is a must-have for a smart investor
Defensive assets, also known as safe-haven assets, are a particular class of investments which is expected to increase in value when the market is turbulent. They are usually sought after by investors who want to limit their portfolio’s exposure to losses even in economically disparate times. For a trader’s portfolio, it is considered ideal for it to allocate 20% to 30% of it towards defensive assets.
Why are different safe-haven assets known as defensive assets?
- Gold: Gold has been considered a store of value for many generations as its value cannot be affected by interest rate decisions made by any national government, unlike money. Gold is considered as a defensive asset as it serves as a form of insurance against adverse economic events. The price of gold increases due to increased demand when investors pile their funds into gold in times of economic uncertainty in trading markets.
- Consumer product producers: Stocks from consumer product producers such as in industries like healthcare, biotechnology, home supplies, food industry, etc., can be considered as defensive stocks. This is because companies operating in such industries will retain their value, especially during times of economic uncertainty when investor demand for these products increases.
- VIX (Volatility Index): VIX or the volatility index is a standardized measurement unit for measuring volatility in the market. It is often used to evaluate investor fear. As the volatility index involves large-scale reactions, investors and traders are enticed towards trading based on VIX. As a result, there is also increasing demand for VIX linked exchange traded funds or ETFs. The iPath S&P 500 short term futures ETN (VXX) is considered as the largest and most liquid. It’s a highly speculative instrument, which increases in value as the market falls, making it a good addition to one’s portfolio.
- Cash: Although being considered as one of the only true haven during periods of economic downturn, cash is negatively affected by inflation and offers no real yield or return.
Rebalancing Portfolio is important
Rebalancing refers to the process of periodically buying or selling assets in a portfolio, in order to maintain a desired or original level of asset allocation or risk. Primarily, rebalancing helps investors safeguard their portfolio from being exposed to undesirable risks. The performance of a stock can vary more dramatically than any other investment option. Thus, the percentage of assets associated with stocks in a portfolio must be regularly reviewed and changed according to prevailing market conditions. To ensure this, traders have to constantly review the assets on a weekly basis to understand which assets are winning and which are losing. They should immediately cut bad positions to minimize losses and replace the asset according to the asset allocation rules set by the trader for the portfolio.
Of all the rudimentary rebalancing approaches, calendar rebalancing is the most frequently used. The strategy involves the trader analyzing their investment holdings within a portfolio. This is done at predetermined time intervals and is used to adjust the original allocation at the desired frequency.
An ETF or Exchange Traded Fund refers to a type of security that consists of a collection of securities (usually stock), which often tracks an underlying index. It is in many ways similar to a mutual fund, with the main difference being that they are listed on exchanges. Shares of ETFs trade throughout the day, just like an ordinary stock.
Many people tend to go for ETFs rather than normal stock because of the lower degree of research involved. In situations where it becomes difficult to choose the best stock from any industry or when there is simply not enough time to conduct deep fundamental and technical analysis, traders and investors can instead go for ETFs of a specific industry or sector.
ETFs can thus be a great way to diversify one’s investment portfolio, as it is one of the fastest-growing investment products on a global scale. It provides a cost-efficient and simple method through which one can easily add investment diversification. Diversification through ETFs can help reduce investment risk. This is due to the portfolio being allocated across a range of different asset classes, companies, and sectors. The spreading of investments in this way can balance out losses even if one area of the portfolio does not perform well.