Investment “experts” always tout the importance of a diversified portfolio. Today I am going to explain exactly what that means and how you can build your own diversified portfolio without paying an “expert” to do it for you.
What is a Diversified Portfolio?
A diversified portfolio is a portfolio containing a large number of securities from a variety of asset classes.
Diversity does not mean ten tech stocks. It means owning multiple stocks across multiple asset classes. If you own only tech stocks, and the tech sector has poor results, all of your stocks will go down together.
Diversification means your exposure goes across many sectors, investment classes, and even countries.
A diversified portfolio contains stocks, bonds, and alternative investments. It includes investments in the United States and abroad. It includes low risk companies, such as blue chip stocks listed in the Dow Jones Industrial Average, and mid-cap and small-cap stocks that contain more risk. It also includes stocks across many sectors, such as consumer goods, technology, construction, telecom, and elsewhere.
Diversity Helps Lower Risk
Why go through all this work to diversify your investments? That’s easy. Diversity helps lower your risk of taking a big loss across your entire portfolio.
Let’s use the bad portfolio above as an example. If you invest only in tech stocks, you may do really well if the computer and internet industries report strong results, but if the industry heads the other way, your portfolio will take a big hit.
If you are invested across multiple industries, you might not ride as high if one of them does particularly well, but your losses are more limited if one of them does poorly. The same goes across countries and asset classes to some extent as well.
The more different companies, industries, and diverse investments you make, the more you are protected from investment risk concentration.
One Stop Shop Diversity
If you are looking to diversity your portfolio the easy way, look no further than a quality index fund or mutual fund.
To get exposure across 500 of the top companies in business today, you can invest in an S&P 500 fund. For a broader investment, look to a Russell 2000 fund. You can also invest in other index funds, including foreign and industry specific funds that give you exposure to multiple companies in a specific region or industry.
If you want professional fund managers to take care of it for you, you can also look to diverse mutual funds. I prefer low fee mutual funds. I put together a portfolio of mutual funds that gives me exposure to hundreds of companies to help me spread my risk.
To ensure I keep track of my fees and investments well, I use the free tool Empower. It only takes a few minutes to sign up and saved me $300 per year in mutual fund fees.
Building Your Own Diverse Portfolio
If you have a large stockpile of cash to invest, you can build your own diverse portfolio. Just know, that it is much more difficult to build a diverse portfolio on your own.
Also know, picking stocks is much harder than investing in a market fund like an S&P 500 fund. Even most professional advisors have trouble beating an S&P 500 fund consistently.
Invest for Your Goals
At the end of the day, remember that you are not investing for diversity or picking stocks, you are investing for a goal. Whether it is retirement, a new home, or your kids future education, make sure your risk profile matches your goals. Think through your investment strategy before you start investing.
How do You Invest?
What is your investment strategy? Do you invest to spread out your risk? How do you diversify? Please share in the comments.
Image by jam_90s / flickr
3 thoughts on “What is a Diversified Portfolio and How can I Build One?”
I’m a dividend growth investor so I try hard to diversify across different industry sectors and companies. I’m not as diversified as I’d like to be at the moment, but I hope that over time I’ll be able to reach the level of balance that I want.
I’m looking into other asset classes to diversify into as well. But I haven’t made any solid decisions yet.
Ever looked into a dividend growth mutual fund to get a big basket of stocks at once?
I generally dislike mutual funds. Too much spraying money everywhere without any attention to actual valuation.
I invest in an S&P500 index fund in my 401k because that’s the best choice available. Other than that, I prefer to pick my own investments.
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