While investing is a way to gain financial freedom, when you pump all your money into just one company or asset, you are actually flirting with danger or maybe even disaster. To put it simply: never put all your eggs in the same basket.
What Is Diversification?
Diversification is a risk management technique that advocates having a wide variety of investments within a portfolio. The rationale is that a well-diversified portfolio will yield better returns and pose a lower risk than a portfolio that is focused on a single investment.
Diversification is a key investment strategy for the world’s high net worth individuals(HNWI).
According to the latest World Wealth Report, HNWIs in Asia Pacific (excluding Japan) increased their equity allocation from 23.3% in 2016 to 27.7% this year. While equity may constitute the biggest proportion in their asset allocation, the rest of their investments are diversified in cash and cash equivalents (24.9%), real estate (18.7%), fixed income (18.3%), and alternative investments (10.4%).
Interestingly, Japanese HNWIs prefer to allocate close to half of their financial assets to cash and cash equivalents (46.5%). They allocated the balance of their portfolios to equities (25.0%), fixed income (13.2%), real estate (8.0%), and alternative investments (7.4%).
Achieving Proper Diversification
As each asset class poses different levels of risk and return, it is crucial for investors to diversify across the board, allocating their investments into a wide variety of assets such as cash, bonds, stocks, real estate, and alternative investments to achieve proper diversification.
For example, equities typically offer the highest potential return but also present the highest level of risk. Hence, it is ideal to invest in a combination of more volatile but high-yielding assets such as equities, and more stable but low-yielding investments like bonds and fixed income.
Nevertheless, there is no one-size-fits-all, universal solution when it comes to allocating assets within an investment portfolio as each investor is unique and has different financial goals and risk appetite. When trying to determine the right asset allocation that will enable them to achieve diversification, investors need to consider the following key factors:
Younger investors should consider allocating a bigger portion of their investment to stocks, since time is on their side to reap the benefits of the compounding gains of stocks and ride out any periods of volatility in markets. Older investors may want to focus more on fixed income assets that are less prone to volatility and produce stable returns such as bonds, as they are nearer to retirement and may not want to take on unnecessary risk.
Conservative investors who prefer to preserve their capital and avoid market fluctuations should consider a higher allocation to bonds and other low volatility investments, while those with a higher risk appetite may opt for a higher exposure to equities in their portfolios.
A Conservative Investment Portfolio Typically Looks Like This:
An Aggressive Investment Portfolio Typically Looks Like This:
A general thumb of rule in investing in individual stocks is to choose stocks across a variety of sectors with the majority of holdings in larger, more established companies.
Also, investors should diversify among domestic and international stocks to insulate their portfolios against volatility that may occur in one particular geographic location or region.
Alternatively, consider mutual funds and exchange-traded funds, as both offer investors diversification by mitigating their risks and losses while exposing them to an entire market or market segment.
Investors should also determine what their long- and short-term goals are, in order to build a portfolio that matches their financial needs and ambitions. For example, if you are planning to retire in another 20 to 30 years, equities would be a suitable investment tool as you need not worry about short-term fluctuations in the stock market. However, if you plan to use part of your investment to fund your child’s education or a lavish wedding in the next few years, a higher proportion of safer fixed-income investments would be preferable.
Your financial circumstances are also a key factor in determining the right asset allocation for you. For example, a HNWI would probably feel more comfortable allocating a higher proportion of his or her portfolio in equities than a fresh graduate, since the former has a higher amount of disposable cash on hand. Likewise, investors with more significant financial commitments and limited amounts of investible assets may prefer the added stability that bonds provide.
The Bottom Line
While achieving diversification will not guarantee that your portfolio generates strong returns, it will definitely help to reduce the level of risk. It is important to note that diversification is never a one-time task. As you age, your priorities and financial situation change. Therefore, it is always a good idea to reassess and rebalance your existing portfolio – to fine tune your asset allocation to match your current investment goals.
Speak with a wealth services professional to find out how to construct an investment portfolio with the optimal asset allocation for you.