Mix Them up to Diversify
No one can accurately predict the future, so investors are advised to diversify in order to reduce overall risk. If your portfolio includes a variety of assets, a decrease in the rate of return of one particular asset will not heavily affect the performance of the portfolio.
- Emma diversifies her investment by allocating 40% in stocks, 40% in bonds, and 20% in cash. If the stock market unexpectedly crashes, only 40% of Emma’s portfolio is affected.
- Cheryl only invests in stocks. If the stock market crashes, her entire investment portfolio will suffer the damage.
It is recommended to diversify your portfolio by including different assets that have little correlation with one another.
- Asset correlation: stocks and bonds may help in diversifying an investment portfolio since both have a different mode of return. While a stock’s return depends on the financial performance of the company, bonds provide interest on the investors’ lending.
- Industry correlation: If you invest in both the automotive industry and steel industry, note that they are highly correlated. If the automotive industry is not doing well, it will buy little from the steel industry, which in turns hurts the steel industry. Thus investing in both industries will not diversify your portfolio very much.
Build a Diversified Portfolio
Choose financial products that belong to different asset types, geographies, sectors, issuer company type, and issuer company size.
Pam has $1,000. 1) She can either her entire $1,000 in a water index, ETF W, which is a commodity only, or 2) she can put $500 in an ETF W and the other $500 in an ETF IT that tracks an information technology index, to make her investment more diversified.
Now let’s say that within a year, the ETF W’s price goes down by 20% and the ETF IT’s price goes up 30%. In 1 year, here’s the value of Pam’s investment:
- Option 1 is $800 {=$1000 - (20% * $1000)}
- Option 2 is $1,050 [={$500 - (20% * $500)) + $500 + (30%* $500)}]
