One of the top investment tips you’ll hear from experts is to diversify your investments. But what does that mean and how do you get started?
What is a Diversified Portfolio?
A diversified portfolio is generally made up of mutual funds or exchange traded funds (ETFs) that have holdings across a broad range of investments and companies–for example, a mix of stocks and bonds to start and perhaps real estate (in the form of REITs) and commodities, too. There are other factors as well; the size of the company (small, mid or large cap), geographic location (US, international or emerging markets) and various sectors (health care, financials, energy). A diversified portfolio is preferable to just a few holdings because over the long run, it should have higher returns with less volatility. So, how do you build one?
Building a Diversified Portfolio
You want to come up with a mix of investments that is appropriate for you. Think about how much you could see the price of these investments drop (your risk tolerance) and the timeline in which you’ll need to use these funds (your time horizon). Let’s say these funds are for retirement and you are in your early 30s. If that is the case you will have the majority of your holdings in stock funds. However, if these funds are for a child who will be attending college in seven years then the mix of assets will look different, and it is likely you would want to purchase a greater mix of bond funds as you invest for that goal. You create percentages for various types of investments. This is your asset allocation. Then you purchase funds that meet those percentages. Now you have a diversified portfolio!
As the holdings in your portfolio perform differently (some might go up and others down) then you can sell some and purchase others to return the portfolio to the original percentages. Or you could add money to the account and purchase underperforming funds which would also return the portfolio to those originally percentages. This is called rebalancing. It is important because it’s a systematic (vs. emotional) way to buy low and sell high while staying in the market.
This is a broad topic, the scope of which extends well beyond this post. If you’re interested in learning more about portfolio diversification and asset allocation I recommend the following books and resources. Charles Schwab offers this explanation which includes some straightforward visuals. The Securities and Exchange Commission (SEC) gives an explanation of asset allocation and rebalancing here. Recommended reading includes Roger C. Gibson’s Asset Allocation Balancing Financial Risk and The Intelligent Asset Allocator by William Bernstein.
Building and maintaining a diversified portfolio will help you manage your investments in a rational way and SaveUp over time!
This post was written by SaveUp’s personal finance contributing writer, Catherine Hawley, CFP®.
Image source: Pando Daily