This article will focus on diversifying your investment portfolio by investing in equities. Of course, it is good to diversify across assets as well, but that is not the main focus of this article.
When the market is on the rise, it seems almost impossible to sell a stock for less than the price you bought it for. However, because we can never be sure what the market will do at any given time, we must not forget the importance of a well-diversified portfolio in any market condition.
To create an investment strategy that will mitigate potential losses in a bear market. Simply put, you should never put all your eggs in one basket. This is the central thesis upon which the concept of diversification rests.
Why should I diversify?
Diversification helps investors “not put all their eggs in one basket”. The idea behind diversification is that if one stock, sector or asset class falls, others can rise. This is especially true if the securities or assets held are not closely correlated. We saw this situation beautifully at the start of the war in Ukraine, when technology companies fell significantly and energy companies shot up. Mathematically, diversification reduces the overall risk of a portfolio without reducing its expected return.
Read on to learn why diversification is important for your portfolio and five tips to help you make smarter decisions and perhaps invest your funds more carefully.
5 Tips to Diversify Your Portfolio
Diversification is not a new concept. In retrospect, we can criticize the swings and reactions of the markets that began to flounder during the dotcom bubble crash at the turn of the millennium, the 2008 financial crisis, and again during the COVID-19 pandemic.
We should remember that investing is an art, not a knee-jerk reaction, and it is time to practice disciplined investing with a diversified portfolio before diversification becomes a necessity. By the time the average investor “reacts” to the market, 80% of the damage has already been done. Here, more than elsewhere, a good defense is the best defense, and a well-diversified portfolio combined with an investment horizon longer than five years can help you through most storms.
1. Spread the wealth
Stocks are a proven long-term security for investors, but don’t put all your money in one stock or one sector. Consider creating your own virtual mutual fund by investing in several companies you know, trust and even use in your daily life.
But stocks aren’t the only thing to consider. You can also invest in commodities, exchange-traded funds (ETFs) and real estate investment trusts (REITs). And don’t just stay with your domestic stocks or U.S. stocks. Think outside the box and take on the world. That way you spread your risk, which can lead to bigger gains, but most importantly, more security.
People will argue that investing in what you know will leave the average investor too heavily retail-oriented, but knowing a company or using its goods and services can be a healthy and beneficial approach to the industry.
Still, don’t get caught in the trap of going too far. Make sure you stick to a portfolio that is manageable. There’s no point investing in 100 different instruments when you don’t really have the time or resources to do so. Try to limit yourself to about 15 to 30 different investment assets.
2. Build your portfolio
Replenish your investments regularly. If you have CZK 100 000 available, use cost averaging to invest that investment over time. This approach is used to smooth out the peaks and troughs caused by market fluctuations. The purpose of this investment strategy is to reduce investment risk by investing the same amount over time.
By dollar cost averaging, you invest your money periodically in a specific portfolio of securities. Using this strategy, you buy more stocks when prices are low and less when prices are high. Using the example of spreading $100,000 over a year, you buy regularly at $5,000 per month, but if stock prices fall for 4 months in a row, feel free to buy this month at $15,000. Think the other way around and use the power of compound interest.
3. Include index or bond funds
You may want to consider adding index or fixed income funds to the mix. Investing in securities that track different indexes is a great long-term diversifying investment for your portfolio. By adding some fixed income solutions, you further hedge your portfolio against market volatility and uncertainty. These funds try to match the performance of broad indexes, so rather than investing in a particular sector, they try to reflect the value of the bond market.
These funds often feature low fees, which is an added bonus. It means more money in your pocket. Management and operating costs are minimal, as these funds need to be run.
One potential drawback of index funds can be their passively managed nature. While hands-off investing is generally cheap, it can be suboptimal in inefficient markets. Active management can be advantageous, for example, in fixed income markets, particularly in challenging economic periods.
4. When to sell?
Buying, holding and cost averaging are sensible strategies. But just because you have your investments on autopilot doesn’t mean you should ignore the forces at work.
Keep up-to-date on your investments and monitor any changes in overall market conditions. Want to know what’s going on with the companies you invest in. This will also allow you to know when it’s time to cut your losses, sell and move on to the next investment. Getting out of an investment is very difficult for many smaller investors and they don’t know how to do it very well. In fact, it’s best to get out during times of growth when the charts are just turning green. And nobody wants to do that.
5. Keep a close eye on commissions
If you’re not the business type, understand what you’re getting for the fees you’re paying. Some firms and investment platforms charge a monthly fee to hold shares, while others charge transaction fees. These can definitely add up and reduce your bottom line. Also important is how much you pay in dividend tax if you have dividend-paying stocks in your investment portfolio. Compare investment platforms and choose one that suits you and has low fees. For example, XTB has zero fees for holding stocks and the lowest possible tax rate for US titles at 15%.
Be aware of what you are paying and what you are getting in return. Remember that the cheapest option is not always the best option. Keep up to date on whether there have been any fee changes.
ETFs as a diversification winner
By definition, an index fund or ETF replicates an index, a large block of stock companies. Depending on what index it is, it may be more diversified than others. For example, the best-known S&P 500 index has more than 500 stock titles, while the Dow Jones Industrial Average has only 30, making it much less diversified.
Even if you own an S&P 500 index fund, it’s not necessarily a diversified portfolio, as you should include other low-correlation asset classes, including bonds, as well as moderate allocations to commodities, real estate and alternative investments, among others. In general, experts advise novice investors to put roughly 75% of the portfolio in a few ETFs and only 25% in stocks of your favorite companies of choice.