How to Diversify Your Portfolio

To achieve a well-diversified portfolio, it’s essential to include a mix of different asset classes such as stocks, bonds, real estate funds, international securities, and cash.

Why Is Diversification Important?

Each asset category offers unique benefits:

• Stocks: Drive portfolio growth.
• Bonds: Provide steady income.
• Real Estate: Acts as a hedge against inflation and has low correlation with stocks, potentially rising when stocks fall.
• International Investments: Contribute to growth and help maintain purchasing power in a global economy.
• Cash: Ensures security and stability for your portfolio.

Developing a Diversification Strategy

Determining the right allocation for each asset category involves a few key steps:

Basic Rules for Diversification

1. Emergency Fund: Set aside enough cash and income investments to cover emergencies and short-term goals.
2. Age-Based Allocation: Use the rule of thumb: Subtract your age from 100 to determine the percentage of your portfolio to invest in stocks, with the remainder in bonds. For example, a 20-year-old would invest 80% in stocks and 20% in bonds.

Fine-Tuning Your Portfolio

To further diversify within these broad categories, consider the following adjustments:

• International Securities: Allocate 10% to 25% of your stock investments to international securities. Younger and wealthier investors might opt for a higher percentage.
• Real Estate Investment Trusts (REITs): Deduct 5% from both your stock and bond allocations to invest 10% in REITs. These hybrid investments offer stock-like returns, primarily through dividends, and their volatility can help stabilize overall returns.

For example, a 20-year-old investor would have an emergency fund and allocate the remaining assets as follows: 75% in stocks (with 25% of that in international stocks), 15% in bonds, and 10% in REITs.

Diversifying Within Asset Categories

Simply diversifying across asset categories isn’t enough; you also need to diversify within each category. For instance, owning a variety of stocks from different industries protects against sector-specific downturns.

For investors with limited funds, buying individual stocks can be costly due to trading fees. A more cost-effective approach is to invest in mutual funds, which pool money from many investors to buy a diversified mix of stocks, bonds, real estate, and international securities. Index funds, which track specific market indexes like the S&P 500, offer a straightforward way to achieve diversification.

Balancing Risk and Return

While diversification helps protect against significant losses, it can also lower your average annual returns because risk and reward are correlated in financial markets. It’s important to find a balance that suits your risk tolerance and investment horizon.

Some argue that the traditional rule of thumb (subtracting your age from 100) is too conservative, especially for younger investors who have a longer time horizon. An alternative is to subtract your age from 110 to allow for a higher allocation in stocks.

Seeking Professional Advice

This overview covers basic strategies for diversifying your investment portfolio, but achieving optimal diversification can be complex. Utilize available resources such as investment books and financial advisors to help tailor a strategy that fits your specific needs and goals.