“Don’t put all your eggs in one basket” is an age-old proverb that serves as a warning against investing all your resources in a single source. The idea behind this proverb is to spread out your assets to mitigate risk and increase returns. This is where portfolio diversification comes into play.
Why Build a Diversified Portfolio?
Portfolio diversification is all about complementarity. By selecting investments that move in opposite directions in specific environments, you can decrease the overall risk of your portfolio. For example, imagine investing in a package delivery company and a videoconferencing platform company. While both investments may be risky, they are in different industries. If a gas shortage were to occur, the package delivery company’s stock price might drop while the videoconferencing platform company’s stock price could increase. This diversification of investments spreads out the risk and safeguards your capital.
3 Strategies for Portfolio Diversification
To achieve a well-diversified portfolio, consider these three strategies:
1. Individual Asset Diversification
Invest in an array of assets within an asset class. This could involve buying the market index or consciously investing in complementary industries.
2. International Market Diversification
Look abroad and invest in international markets to balance your portfolio and mitigate risk.
3. Asset Class Diversification
Diversify your investments across different asset classes, including traditional investments (stocks, bonds, and cash) and alternative investments. Alternative investments are a great addition to portfolios due to their low correlation with traditional assets.
What Are Alternative Investments?
Alternative investments refer to any investment besides stocks, bonds, and cash. They are relatively illiquid and unregulated by the United States Securities and Exchange Commission (SEC). Some common types of alternative investments include hedge funds, private equity, real estate, debt investing, commodities, collectibles, and structured products. These investments provide a low correlation to traditional assets, making them ideal for diversifying your portfolio.
Factors to Consider for Diversified Portfolios
When selecting alternative investments, consider the following factors to ensure diversification:
Time Horizon & Liquidity
Traditional investments are fully liquid, while alternative investments tend to have longer time horizons and are relatively illiquid. It’s important to diversify your portfolio with investments that have different time horizons to provide flexibility and security.
Markets & Industries
Diversify your portfolio by selecting investments from various industries and markets. Explore industry trends for the private companies you’re considering and select companies in industries that complement each other.
Risks & Potential Threats
Consider the types and levels of risk already present in your portfolio and choose alternative investments that complement them. Longer time horizons generally mean less immediate risk, but physical assets may carry additional risk.
Using Alternative Investments to Diversify Portfolios
Alternative investments are key to building a strong and diversified portfolio. Understanding the characteristics of each investment type, such as time horizons, liquidity, industry and market trends, and risk levels, will help you select alternatives that mitigate overall risk and increase returns. Consider taking an online course like Alternative Investments to deepen your knowledge and intuition for building well-rounded portfolios.
Are you interested in learning how to build strong investment portfolios? Explore our five-week online course Alternative Investments and other finance and accounting courses. Download our free Financial Terms Cheat Sheet to enhance your financial fluency.
