The extreme volatility introduced to the markets in 2020 amid the COVID-19 pandemic has brought back to the table the importance of having an adequately diversified portfolio through which investors can both expand their gains and limit their losses during times in which the performance of financial instruments can widely vary from one to the other.
For investors, diversification is a powerful tool to produce steady returns over time, especially when the person does not have that much experience in analyzing individual securities, which is the case for most first-time investors.
In this article, we will explain three ways in which investors can diversify their portfolios by using a combination of exchange-traded funds (ETF) and other similar instruments to get broad exposure to multiple asset classes, economic sectors, and geographical markets.
1) Diversifying your asset classes
An asset class is a particular category of financial instruments that share similar characteristics such as the way they generate cash flows for the holder, their implicit risks, and the regulations that apply to them.
Broadly speaking, asset classes can be divided into four major groups: equities, fixed-income securities, cash, and alternative investments.
Equities refer to common stocks specifically while fixed-income securities include preferred shares, bonds, and other similar instruments that pay investors a fixed amount periodically.
Cash includes both money in hand or in a bank account, while it also includes cash equivalents like money market funds and other highly liquid instruments.
Finally, alternative investments are those that do not fall in any of the above-mentioned categories and they include investments in art, digital currencies (i.e. Bitcoin), private equity, patents, licenses, and multiple other investment vehicles.
Investors can use a combination of these asset classes to diversify their portfolio, following a specific capital allocation policy that will ultimately determine the percentage that will be placed in each of these classes and sub-classes.
If done adequately, investors can use this strategy to both expand their returns while keeping their portfolio’s volatility in check.
2) Diversifying through sectorial and geographical exposure
When it comes to selecting a particular investment vehicle, whether that is a bond or a stock, the issuer’s industry and geographical location can be of great importance in the process of analyzing if such an investment will have a positive impact on the portfolio or not.
For example, an industry that has been in decline lately cannot be considered as a positive addition to a portfolio unless there is a possibility that the situation turns around over time.
Meanwhile, a financial instrument issued by an entity that is located in a highly unstable country adds significant risk to the portfolio that is not necessarily compensated by the return produced by such instrument.
In this regard, investors should analyze the sectorial and geographical exposure of their portfolios to make sure that they can incorporate a mix of up-and-coming industries and countries, while also deploying a big portion of their assets on stable choices that can keep volatility in check.
3) Alternative investments as a separate diversification tool
Alternative investments have been gaining popularity among investors since the financial crisis of 2007-2008, as interest rates have remained historically low amid the government’s intervention in the markets.
These investments could go from real estate to art, to Bitcoin, and their potential returns and volatility vary widely depending on the economic cycle and other elements.
That said, they can also provide an interesting opportunity for investors who are seeking to diversify their portfolios in a non-traditional fashion by incorporating assets that can yield interesting dividends and capital gains if they are adequately selected.
However, keep in mind that alternative investments are often more volatile and complex to analyze than traditional assets like stocks and bonds, which means that you should seek advice before engaging in this sort of operations.
How to choose the right mix for your portfolio?
The right mix for a portfolio depends on multiple factors including the investor’s age, income, job situation, financial goals, and risk tolerance, among others.
Each of these variables has to be analyzed before deciding which asset classes should get the biggest percentage. For example, a young investor with a small account balance might be comfortable with taking significant risks, while a soon-to-be-retired engineer who has a sizable retirement account can feel extremely uncomfortable with the idea of investing in highly volatile instruments.
In this regard, a financial advisor can help you in designing your portfolio in a way that serves your financial goals, while you could also establish your own mix following the strategies suggested above.