5 Smart Ways to Diversify Your Portfolio

Diversification is essential to building a healthy investment portfolio. Portfolio diversification is largely responsible for balancing the risk and return of investment and reducing so-called cluster risk by broadly spreading the portfolio’s contents. This diversification is essential for getting a profit in a long term.

What Is Diversification?

Diversification means the division and spreading of capital across different assets. For example, money can be invested in different industries or asset classes in order to reduce the risks of individual investments.

To put it simply: for a good and diversified portfolio strategy, investors invest not only in manufacturers of umbrellas but also in manufacturers of sunshades. This way, all investments never sink at the same time and investors are well prepared for all market conditions.

Diversification is considered an important part of successful and sustainable asset accumulation. Most online brokers, especially professional ones, like Brokstock or Fidelity, even offer a bit of advice on the correct diversification of your portfolio.

Benefits of Diversifying Your Portfolio

Any financial investment is characterized by an interplay of three features: safety, availability, and return. These three characteristics are represented in different proportions depending on the investment and can never be fully covered by one investment.

This basic rule is often illustrated in the financial market by the magic triangle of investment, the three corners of which represent security, availability, and return. Each investment can therefore be classified either in one corner or on the line between two corners.

Anyone who places a lot of value on security when investing money can go for a fixed-term deposit account but must make sacrifices in terms of return and availability. On the other hand, those who want to remain flexible in accessing their money can use shares for this purpose but will have to deal with an increased risk.

This is where diversification comes in. One part of the portfolio is safe, another is always available and the third has a high return. This way, the rule of the magic triangle can be bent to some extent. The more assets are represented in the portfolio, the better the characteristics of the individual investments balance each other out.

With a broad diversification of their investment and the combination of different investments, investors have the advantage of being able to combine all three properties in their portfolio.

So, the advantages of diversification include:

• Reducing the overall level of risk. Diversification reduces the specific risk associated with a particular company, region, or industry. If some stocks in a portfolio fall, others can rise and reduce losses.
• The ability to invest in potentially profitable but risky assets in which you would not invest all of your money. In a diversified portfolio, they won’t increase your overall risk level.
• Protection against market volatility, when the prices of securities fluctuate wildly, jumping up and down.
• In the long run, a diversified portfolio can help increase overall returns.

There are a few ways to diversify the portfolio. Some will be more suitable for your particular investment strategy than others.

Smart Way #1: Invest in Different Types of Assets

The idea here is not to invest the entire capital in a single asset class. For example, stocks may be particularly popular but there have been numerous crashes in history where shareholders have lost a large portion of their money because the stock market collapsed across the board.

Investors who had invested only parts of their money in stocks, but the rest in bonds, time deposits, and real estate, for example, were better able to cope with such a slump.

Smart Way #2: Invest in Different Sectors

Diversification by sector is particularly widespread for equities and ETFs but is also relevant for real estate investments. Here, investors take care to invest in sectors that do not correlate strongly with each other, so that any losses can be offset.

For example, anyone who invested in tourism, gastronomy, and aviation at the same time during the Corona pandemic had to expect considerable losses, as these sectors were badly affected. However, those who had invested in certain biotechnology companies at the same time were able to partially compensate for the losses.

Smart Way #3: Invest in Different Geographies

Make sure your savings are not overly concentrated in one region. For example, if you have in your portfolio only stocks of U.S. companies, mutual funds focused on the U.S., and bonds of U.S. companies, don’t be surprised that you will suffer heavy losses when the U.S. economy weakens.

On the other hand, if you had also invested in European and Asian markets, you could probably offset the losses with gains in other areas. Even riskier is a concentration on smaller and less developed countries and regions, whose economic development is often characterized by high volatility.

Smart Way #4: Invest in Different Investment Vehicles

Diversification can also be applied to investments outside the stock market. Spreading capital across different investment vehicles can reduce the risk of loss.

The popular investment vehicles include:

• Ownership investments;
• Lending investments;
• Pooled investment;
• Cash equivalents.

By diversifying this way, you significantly reduce the risks and increase potential profits. Lending investments have seen a big surge in popularity over the past few years and many instruments that have enabled easy access to these investments have emerged.

Smart Way #5: Invest in Different Time Horizons

The last form of diversification relates primarily to fixed-term investments – such as time deposits. Here, investors should make sure that their investments do not all «mature» at the same time. This can make reinvestment difficult – for example, in times of low-interest rates – and put a strain on liquidity.

Final Thoughts

There is no one perfect way for private investors to build a successful portfolio or securities account. Rather, investors should take care to realistically assess their own situation and personal goals in order to tailor the investment portfolio to their individual risk-return objectives.

For those looking for a balanced ratio, diversification offers the opportunity to make safe investments and thus include all sorts of asset types in their portfolio.