Nearly everyone who has an investment is encouraged to review their investments periodically to ensure that they remain diversified. In-the-know investors understand that there are different types of diversification that must be considered; your mix of asset classes, geographies and sizes are some differences between types of investments that, when held together, may increase your portfolio return while reducing risk over periods of time. Let's look at three steps you can take to make sure you attain a truly diversified portfolio.
Step 1: Review Your Entire Asset Base
One of the first mistakes investors make is only reviewing a single group of investments within a portfolio. Some investors have numerous brokerage accounts, money market accounts, life insurance policies, CDs and possibly mutual fund investments. When you are considering diversifying your portfolio, you need to review all these types of investments and accounts as if they are one portfolio.
It is important to look at all investments because you could be over-investing in a single sector without realizing it. For example, if you have a mutual fund that is focused on technology, you may want to avoid investing in technology companies in other investments or accounts. The same thing applies if you have a money market fund; you may not want to have as much in cash in another investment account. (For related reading, see: Why and How to Diversify Beyond Asset Class.)
Step 2: Make Sure You Have an Investment Goal
In order to make smart decisions, all investors must first set a goal for what they expect to achieve with their investments. This means not only determining what type of returns you are interested in getting from your investments, but also understanding your risk tolerance. Without these two components, it is impossible to determine what types of investments are best suited for your portfolio.
Keep in mind there are investments available for those who have any imaginable risk tolerance, low or high. Those who are chiefly interested in protecting their investment dollars may elect to invest in stable but low-return government bonds, while those with a higher risk tolerance may opt to buy riskier issues of bonds that offer the chance for a higher return on investment. Diversification would suggest that you own different amounts of each type of investment while your risk tolerance will guide you to how much of each to own.
Step 3: Invest, Monitor and Adapt to Changes
Working with your investment advisor, you should allocate your portfolio into a mixture of stocks, bonds, alternative investments like commodities or real estate investment trusts and exchange traded funds (ETFs). The best mixture takes into consideration the risks of the sector, geographic risks and company sizes that may apply to the investment. Once your portfolio is set, your investment advisor will help you monitor your investments and determine when it may be necessary to sell an investment or consider reallocating to minimize risk or maximize returns.
Diversification is important for many reasons, including understanding what impact a single news story, political issue or interest rate change could have on your overall portfolio. Working with an advisor who is forward-thinking, experienced and takes into consideration your goals and objectives is crucial to your long-term investment success. Remember, the ultimate goal of a diversified portfolio is to reduce the potential volatility of your investments and maximize the potential returns you may get on those investments. (For related reading, see: Rebalance Your Portfolio to Stay on Track.)