Five Ways to Diversify Your Portfolio
CATEGORIES: Investment Planning
We talk a lot about diversification here at Jemstep – the reason being that it is a matter of fundamental importance for smart long-term investing. Research shows that a well-diversified portfolio not only protects investors from steep bouts of market volatility, but also improves returns over the longer term. Here are five easy ways to get started with a prudently diversified portfolio:
1. Include both stocks and bonds
You may be surprised by how many portfolios flunk this basic test. Aggressive investors seeking high capital returns think bonds are a drag on performance, while the risk-averse types regard the stock market as a glorified casino and avoid the roller-coaster ride entirely. Neither of these approaches makes sense. If you are young with a long career ahead of you and plenty of capacity to tolerate risk you should certainly allocate substantially more of the portfolio to stocks than bonds – but a cushion of 20% or so in fixed income can be an important counterweight, especially in highly volatile market conditions. Likewise, bonds are not always safe investments. There is a reasonable chance interest rates will rise substantially over the next decade or so, which will cause bond prices to go down. Equities can provide alternative sources of returns and are especially important for those whose near-term income needs are reasonably flexible.
2. Invest in non-US assets
The world has grown more connected, but there is still something of a mystique associated with investing outside one’s home market. There shouldn’t be. Most of the growth taking place in the world today is happening outside the US. It is important to have exposure to the assets that are participating in this growth, including emerging markets in Asia and Latin America. Additionally, investing in non-US markets provides a natural hedge against weakness in the US dollar. When you buy into a fund holding, for example, German or Japanese stocks the value of your assets is expressed in Euros or yen. Currency diversification is an important piece of the puzzle. Conduct some mutual fund or ETF research and you’ll see that non-US investments are easily accessible through some high quality funds.
3. Pay attention to style-based investment opportunities
Over the past ten years in the US small and mid cap stocks have performed consistently better than large cap stocks. Over long-term periods value stocks tend to outperform their growth stock counterparts. That is not to say that you should always load up on small caps or value stocks – but make sure you have some meaningful exposure there. You need more than just a proxy for the S&P 500 for an intelligent position in US equities – you need asset classes that will tend to perform well at times when this large-cap benchmark is not.
4. Alternative assets provide low correlation to stocks and bonds
Alternative assets include managed commodities futures, real estate investment trusts (REITs) and hedging strategies like market neutral, long-short or event arbitrage. All these are available via regular mutual funds, and its worth spending a few minutes doing some mutual fund research to find top rated funds in these asset classes. A good rule of thumb is to leave at least 10% of your portfolio for alternative assets. Alternatives can help offset risks in both equities and fixed income securities. Their low correlation means that you have some protection when unforeseen events have a strong impact on the other assets in your portfolio.
5. Rebalance at least once a year
The key to a well-diversified portfolio is to rebalance on a periodic basis so that your allocation weightings don’t become too heavily skewed over time by asset performance. For example if you have 50% of your portfolio in stocks and the market goes on a 5 year bull run your stock weighting will increase accordingly unless you take action on a regular basis (once a year is a good rule of thumb). This may sound counterintuitive – in order to rebalance you have to sell the “winners” and buy the “losers”. But the result is that you are maintaining a disciplined approach that will be more likely to perform well over the long-term in line with the parameters of your own risk tolerance and return objectives.
Always bear in mind that your portfolio requirements will change as your own financial and life circumstances evolve over time. Actual weights you set for different asset classes will change accordingly – but the basic principles of a well-diversified portfolio should largely remain constant.
