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Investing involves risk, but a smart investment strategy can help you mitigate these risks and achieve your goals, regardless of market fluctuations.
Implementing a diversification strategy can be challenging, especially if you’re used to traditional investments in stocks and bonds. But implementing strategic asset allocation and reviewing your portfolio regularly will ensure that your investments can weather market volatility and maintain your financial freedom.
It’s easy to hone in on several high-performing stocks or bonds and spend all your investment dollars on these high-ROI options. However, even these stocks are vulnerable to factors such as market performance and the economy in general. As the financial crisis of 2008 shows, all bubbles eventually burst.
It’s important to note that portfolio diversification won’t completely eliminate risk — you may still experience losses during a market downturn. Instead, diversification helps you reduce risk to a level you’re comfortable with and maintain that risk profile as your circumstances change.
Most people will chase after high-risk investments during market booms and move to lower-risk options during market downturns. The problem with this type of investment strategy is that it leads to missed opportunities, as you’re essentially following the crowd and reacting instead of proactively planning.
If your portfolio consists of several asset classes, you are better positioned to play off market fluctuations to your benefit and stay ahead of the investment curve.
5 Ways to Build a Diversified Portfolio
A diversified investment portfolio has an asset mix that consists of several components, including:
- Stocks and index funds
- Bonds and fixed-income investments
- Short-term investments
- Physical assets
- Real estate
- Private equity
You can tailor this mix to match your risk tolerance, financial needs, and investment time frame. If you’re okay with higher investment risk for better rewards, you can have a portfolio with mostly volatile assets. However, even a high-risk portfolio should include some investments that display steady, if unremarkable, growth.
Broadly speaking, stocks and index funds have a higher capacity for growth but tend to have larger fluctuations that may affect your short- and medium-term gains. Bonds, alternative investments such as physical assets, and short-term investments are generally safer but offer lower returns. While past performance is no guarantee of future success, these trends within asset classes are relatively reliable and should form the foundation of your balanced portfolio.
1. Invest in Stocks
Stocks are one of the most common investment options and comprise a large portion of most people’s investment portfolios. By buying company stock, you’re betting that the company will continue to grow and perform well. If you invest enough, you may even receive dividends as a form of passive income.
But while playing the stock market can reap great rewards, it’s also a high-risk strategy, especially for short-term investments where you don’t have the time to ride out the peaks and valleys.
A potential pitfall of investing in the stock market is failing to diversify your stock portfolio. If you’ve invested in several tech companies, you have essentially invested in one sector, and if that sector experiences a downturn, you’ll make a loss on all of your stocks. For instance, the Nasdaq Composite index, which tracks tech stocks, fell by almost 80% in the dot-com crash in the early 2000s.
As with your overall portfolio, diversifying your stock options allows you to manage risk. Be sure to re-evaluate your portfolio regularly, as chasing high-performing stocks will often lead to an outsized weighting in one or two sectors. You protect yourself from sector-wide volatility by trimming back on stocks in one sector and investing in alternatives.
Buying stocks offers several benefits to the smart investor, including:
- Taking advantage of a growing economy: Stocks generally perform well during economic growth, as companies take advantage of higher earnings and sales.
- Ease of trading: You can buy stocks through a broker or financial advisor or by yourself using an online platform. Once you have an account, you can buy and sell stocks within minutes.
- Relatively low barrier to entry: You don’t need much money to start investing in the stock market. Many brokers don’t have minimum investments and let you buy stock and sell stocks commission-free. Some even allow you to buy fractions of stocks of high-performing companies.
- Multiple forms of income: In addition to making money by buying low and selling high, most companies pay regular dividends to shareholders. The more stock you have in a company, the higher your passive income, as long as the company performs well.
- High liquidity: Stock markets let you sell your shares at any time to convert them to cash. Not all asset classes are equally liquid, and it’s smart to have at least one or two that you can quickly and easily convert to cash for emergencies.
As with all investments, investing in stocks carries risks that include:
- Potential loss of investment: Past performance is no guarantee of future success, and it’s possible to lose your entire investment if your chosen company performs poorly. Stock price drops can be precipitous, especially in emerging markets, and you may risk losing everything if you sell your shares for a lower price than you bought them.
- Professional competition: Buying and selling stocks pits you against seasoned investors and professional traders who have access to better tools and have more experience in trading. This means they’re better placed to capitalize on market changes, and in many cases, their win will be your loss.
Most investors consider a 10% annual rate of return to be a good ROI for long-term stock investments. As with any other projected ROI, this is an average; some years will yield a higher return while others will result in negative returns, which is why stocks are better as a long-term investment.
2. Invest in Funds
Instead of buying stocks in individual companies, many investors choose investments in funds that tie their performance to a specific sector or market, including emerging markets. Funds can vary in their purpose, how investors buy into them, and their performance and risk profile. The most common types of funds are:
- Index funds
- Mutual funds
- Exchange-traded funds
Index funds contain a portfolio that tracks certain financial markets. For instance, the S&P 500 Index contains the 500 largest stocks trading on the New York Stock Exchange. This portfolio means that the index tracks the health of large American companies, and if they do well, so does the fund.
An index fund is generally passive, as the portfolio composition doesn’t often change. They’re ideal as a core investment for individuals who want stocks in their portfolio but don’t have the time or inclination to pick out individual stocks on the market.
Mutual funds are similar to other funds in that they pool assets from investors to invest in stocks, bonds, and other asset classes. What makes a mutual fund appealing as an investment account is that it has a professional manager responsible for asset allocation and portfolio management to achieve its goals.
An exchange-traded fund is similar to a mutual fund, but instead of buying directly into the fund, investors buy and sell ETFs in a similar manner to traditional company stocks. ETFs are popular for asset class diversification because they contain multiple assets while being more cost-effective than mutual funds.
While various types of asset allocation funds have unique benefits, most funds provide the following advantages:
- Immediate diversification: As most funds tie their performance to a particular market, they automatically contain a diverse range of securities, stocks, and bonds.
- Professional management: All funds have professional managers that ensure the fund has a well-diversified portfolio of certain asset classes, giving even novice investors the benefit of their expertise.
While funds are appealing investment accounts, they come with some drawbacks that you need to consider:
- Extensive research required: Not all funds are equal, and many have high fees or a poor performance record. You need to do a lot of research to find high-performing funds with a good ROI.
- Still subject to market volatility: While many funds contain a diversified asset allocation, they still reflect a certain market sector. If that sector or asset class underperforms, so will the fund.
Fund returns vary dramatically depending on the type of fund. Popular funds like the S&P 500 have had an 8.13% return since 2002, while other larger funds have produced returns of up to 12.86% in the same timeframe.
3. Invest in Bonds
Fixed-income investments like bonds provide a stable and predictable investment with periodic interest payments and a return on the principal at the end of the term.
Bonds are the most common fixed-income investment, where banks and governments use investor money to lend money to other companies. Not all bonds sold on bond markets are investment-grade, though, and non-investment-grade bonds represent a higher risk of default but with the potential for higher gains due to higher interest rates.
While fixed-income investments may not yield a substantial gain compared to stocks and funds, they represent an important way to diversify your portfolio and offset risk.
Bonds and other fixed-income options are an excellent asset class to diversify your portfolio. Their major benefits include the following:
- Predictability: Fixed bonds have a set term and interest rate. They provide steady interest income for the lifetime of the bond as well as repayment on the principal after the bond matures.
- Security: While bonds do have varying credit risks and the risk of default is always present, several mechanisms ensure that investors don’t lose their investment.
Bonds and other fixed-income investment options tend to be safe options with relatively low risks. However, they do still have some drawbacks, including:
- Comparatively low ROI: Long-term bond investments don’t perform as well as long-term stock investments.
- Inflation risk: You may start to lose money if the inflation rate outpaces the interest rate of your bond.
The average return rate for a 10-year U.S. Treasury bond is between 3.67% and 4.26%. Corporate bonds tend to have higher returns but remain notably lower than stock or fund returns.
4. Use Your IRA for Portfolio Diversification
Most people use their individual retirement accounts (IRAs) to save money for the future while avoiding tax payments today. However, IRAs are an excellent way to diversify your portfolio, as they can provide an interest-free way to invest in various asset classes.
Self-directed IRAs allow investors to invest in physical assets, including precious metals, paintings, real estate, and even crude oil. What makes IRAs so appealing is that they are flexible. In addition to physical bullion, a gold IRA accepts gold-related mutual funds, stocks, and ETFs.
A common investment strategy is to first invest as much as possible into your IRA (up to the maximum allowed amount), either in alternative assets such as silver or traditional investment vehicles such as stocks, funds, and bonds. If you still have investment money left over, you can continue focusing on a specific investment or diversifying your portfolio further.
Using an IRA as an investment tool offers several benefits, including:
- Flexibility: The IRS allows investors plenty of options when investing in a self-directed IRA. From precious metals and real estate to bonds and stocks, your IRA is flexible enough to take advantage of changing market conditions.
- Tax advantage: The main reason to consider your IRA as an investment vehicle is that any money you invest is tax-deferred. You will still pay tax when you take distributions, but the tax deferment gives you more money to invest and reap the benefits of compound interest and early investing.
Using an IRA to kickstart your investment is a good idea, but self-directed IRAs do come with some downsides, including:
- Limited investment potential: The IRS has strict limits on how much you can invest into your IRA yearly, and going over these limits results in tax penalties.
- Fees: Some IRA funds have monthly fees. For instance, gold IRA companies may charge for handling and storing any physical gold on your behalf and transaction fees for every purchase.
Your ROI will correlate closely to the asset class you invest in. So stocks and ETFs will have a higher ROI than IRAs containing bonds.
5. Invest in Physical Assets
Physical assets, such as real estate, precious metals, or even art, should be a part of your diversified portfolio. Most investors use physical assets to hedge against inflation, as historically, physical assets such as gold rise in value as paper markets and currencies lose value.
Investing in physical goods can open up a new vista of investment opportunities for a diversified portfolio and offers several unique benefits:
- Independent value: The performance drivers for physical assets are usually very different from paper markets, meaning that physical assets will react differently to economic conditions and can act as a hedge against economic downturns.
- Alternative uses: In addition to holding value, some physical assets, such as real estate, can generate passive income during the investment phase.
- Expertise: Certain physical assets, such as commodities and precious metals, require a deep understanding of the industry and market factors affecting prices.
- Tangible risks: Physical assets are vulnerable to physical risks, such as vandalism and theft. Purchasing insurance can help offset these risks.
Physical assets vary dramatically, and so do their returns. Precious metals such as gold had annual returns of 7.78%, while real estate returns varied greatly depending on location, building type, and industry.
The Role of Investment Correlation in a Diversified Portfolio
The main reason to diversify a portfolio is to mitigate risk. While diversification can’t completely prevent losses, it can help reduce their impact. A diverse investment portfolio should have assets with little correlation to each other. For instance, if you focus on stocks as your investment vehicle, it’s important to have shares in companies from different sectors that do not correlate. If one sector starts dipping, you can be confident that the other won’t follow suit because there is typically no correlation in price between investment vehicles.
This lack of correlation is why physical gold and other precious metals are so appealing. Traditionally, gold values are inversely related to market conditions. When the dollar value drops, investors flock to gold, raising its price. When the gold price drops, investors will move back to dollars. By having a stock of gold, you can invest wisely to hedge against losses in your other investments.
Why Doing Your Research Is Important
It’s a good idea to re-evaluate your asset mix regularly to ensure your investment portfolio stays on track with your risk tolerance and financial markets. In some instances, you may need to rebalance with an eye toward higher risk, while in others, you may need to invest in more conservative asset classes.
We recommend speaking to a personal finance advisor to chart the best course of action for your needs.
Diversify Your Investment Portfolio with Oxford Gold Group
At Oxford Gold Group, we recommend pursuing several investment avenues to spread your risk over multiple types of investments.