Every investment carries some amount of risk. Since markets can be volatile and unpredictable, diversifying your portfolio helps maximize returns over the long term as well as better protect yourself against unexpected market downturns.
This article will talk about what diversification is, its importance, and how you can diversify your investment portfolio. Moreover, we will also shed some light on the benefits of illiquidity and how real estate investments can help you enhance your returns.
Let’s get started!
Diversification: Why It’s Crucial for Your Portfolio?
Diversification is the most crucial step in risk management. It is the investment technique of holding unrelated investments across asset classes that react differently to social and economic events.
Diversification is a technique that is crucial for investors to reach their long-term goals as it enables them to hedge against unsystematic risk and build wealth over a period across different asset classes. Using diversification, an intelligent investor reduces the risk by planning carefully and allocating funds across various asset classes.
For instance, in a growing economy, stocks generally outperform bonds. However, when market conditions change, bonds hold their value, whereas stock prices tumble. Thus, if a smart investor diversifies their investment portfolio and holds both stocks and bonds, they can reduce their overall exposure to such change in market conditions and mitigate the risks of their portfolio taking a big hit.
Investment Portfolio Diversification: How to Achieve it?
An investor can diversify their portfolio by using the asset allocation strategy, which involves selecting a combination of investments based on the investors’ risk profile, financial goals, and time horizon.
Each asset class available to investors have different risk-reward ratios, and thus, each performs differently in varying market conditions. For instance, while stocks are more volatile and risky in comparison to bonds, they also offer the potential for higher returns.
Some of the standard asset allocation classes include the following:
- Equities (Stocks and ETFs)
- Fixed Income Bonds
- Real Estate
- Cash and cash equivalents
Diversified Portfolio Example
Source: Cary Stamp & Co.
While diversification is essential, it’s equally important not to over diversify. The best way for an investor to do so is to keep their portfolio at a manageable level that varies for each investor based on their financial goals and risk profiles. For instance, avoiding diversification for some investors could mean only holding six assets in different industries that they are confident about. Whereas, for others, it could mean avoiding investment in certain asset classes that they don’t understand, just for the sake of diversification.
The Benefits of Illiquidity
Liquidity refers to the ease with which an asset can be converted to cash and cash equivalents without losing market value. In general, it is seen that liquid assets such as stocks are more volatile in nature. Thus, to capture the benefits of illiquidity, long-term investors may prefer allocating funds towards illiquid assets.
Typically, illiquid assets have a low correlation to the broader stock market, and thus, they are less volatile in nature, and their value remains stable over a more extended period. As a result, such investments are considered low beta investments that are less risky but offer lower returns. As a result, such investments help minimize portfolio losses when the market sees a downturn.
How to Enhance Portfolio Diversification Using Real Estate
Real Estate Investment is the process of purchasing property to either rent it out or sell it to make a profit. As an asset class, real estate is mainly used for diversification purposes and has helped investors amass generational wealth.
Diversifying your portfolio by investing in real estate offers the following benefits:
- Long-term stability – Real estate market is seen as one of the most stable financial markets. Thus, real estate investment is considered to be a less volatile and stable long-term investment opportunity.
- Usability – Real estate is a tangible asset that investors can use for renting out or for personal use. For example, real estate bought for diversification purposes can be rented out and used to generate additional income.
- Mitigating Risks – Real estate is an illiquid asset and thus, is not highly correlated to the stock market. Hence, many investors use real estate to hedge their risks against more volatile assets in their portfolios.
- Tax Benefits – Governments in many countries offer tax benefits on real estate investment to promote the sale of properties in the country and boost the economy.
Additionally, there are many different ways through which investors can invest in real estate. They are as follows:
- Real Estate Investment Trusts (REITs) – REITs enable investors to invest in real estate even with small amounts of money. Shares of REIT stocks can be bought and sold in the market just like any other publicly listed company.
- Crowdfunding Real Estate Platforms – These online platforms let investors take a more hands-on approach and invest in specific real estate development projects.
- Investing in Rental Properties – Purchasing rental properties enables investors to add an alternative source of cash flow and earn some additional monthly income.
Important Questions to Ask About Your Portfolio Diversification
To diversify your portfolio successfully, an investor first needs to understand the fundamentals of diversification and ask the right questions to evaluate how these fundamentals apply to their specific portfolio.
Here are some critical questions about your portfolio diversification to evaluate your diversification strategy and make more informed choices.
- What is my risk tolerance? – This changes according to investment objectives and time horizon. Each asset class has different risks. Hence, investors must choose an asset class that is suitable to their risk tolerance.
- What is my risk-adjusted rate of return? – This question answers how well you are being compensated for the amount of risk you’re taking.
- How many asset classes should I invest in? – While diversifying your portfolio, it’s important to look for a wide range of asset classes.
As an investor, to achieve your long-term financial goals, you need to balance your risk and reward. Diversification allows you to choose a mix of assets that reduce the risk of losses in the market. Thus, it’s essential to find the right balance between risk and return and select a mix of assets that can help you achieve your financial goals while limiting your exposure to unsystematic risks.