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It’s crucial to have a well-diversified portfolio when trading, as we can never know in what direction the markets will go. When avoiding losses in a deep bear market, it’s important never to put all your eggs in one basket.
To achieve a diversified portfolio, traders and investors must seek out asset classes that are not correlated. This ensures that if a certain trend decreases one asset’s value, the others will not be sabotaged. The easiest way to do this is via ETFs and mutual funds. A good method to follow the 5/25 rule as a guide: “Stick to five different asset classes and don’t have more than 25% of your money in one of them.”
What is portfolio diversification?
Simply put, it is a risk management strategy that involves blending financial instruments from different asset classes into one single portfolio. The practice ensures that your exposure to any single asset type is limited and your portfolio’s volatility is reduced.
There are several components every successful trader should have in their portfolio:
Bonds are generally more predictable than other financial assets and can act as a safety cushion when other financial assets are affected by financial instability. Commonly investors will choose low-risk bonds and hold them long-term in an effort to hedge against market volatility.
Normally, stocks will represent a bigger chunk of a trader’s portfolio since they are usually more lucrative, albeit being riskier. International stocks tend to perform differently from that of the US and may have higher short-term gains.
ETFs and mutual funds offer a simple and straightforward way to invest in a basket of different stocks for instant diversification. While ETFs pool assets into one group and track a specific market index, they trade like common stock, which means they’re affordable. Mutual funds are restricted in trading, unlike ETFs.
Why should you have a diversified portfolio?
Besides reducing risk, portfolio diversification helps minimize the level of uncertainty you face in every financial market. Understandable, if you lock all your money in the stock market, and it crashes, then you will.
Different asset types react differently under various market conditions. By spreading your investments rather than investing in one single asset type, traders allow themselves to have well-performing financial instruments at all times.
What are some diversification best practices to follow?
Creating a well-diversified portfolio can be tedious since there are many investment options out there. Let’s go over three important rules to remember when building a diversified portfolio:
Buy ten or more stocks from various industries – perhaps the quickest way to diversify your company is to buy shares from different industries. Don’t just stick to tech; try healthcare, retail, financial sector, etc.
Keep a portion of your portfolio in fixed income, like bonds. This may reduce your portfolio’s overall returns, but it will also subject you to overall less risk and volatility.
Invest in real estate! And we don’t mean just buy a property. Invest in REITs (Real Estate Investment Trusts). The sector is great for bringing stable and good returns, with low risk and volatility.
Get out on time. While buying and holding is great, cashing out at the right time is CRUCIAL. Stay up to date with your investments and measure your actions in case market conditions change.
We’ve said it once, we’ll say it again – portfolio diversification is important. Educate yourself about different markets and make sure your portfolio contains different asset types that react differently to market changes.
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