How can I diversify and protect my financial future? The present-day stock market is characterized by high highs and very stomach-churning lows. Investors are therefore required to know how and where to invest their money since the failure to do so can expose them to very massive risk. Let’s say you pick a company that is having a bad financial year, you can end up losing a huge chunk if not all of your investment.
Whereas there is no defined approach to prevent the occurrence of the highs and lows in the market, there are legal and acceptable diversification approaches that make it possible for you to mitigate risk and uncertainties. Read on to discover what you can do as far as this investment strategy is concerned.
What is diversification?
Diversification is a fundamental concept of investing based on the old saying, “do not put all your eggs in one basket.” One of the main approaches to successful investing is learning how you can balance your comfort level with the apparent risk, against the defined time horizon.
Investors who approach investment for retirement very conservatively while they are still at a young age, are likely to run at the risk of a very slow growth rate since their investments do not keep up with inflation. On the other hand, those who try to invest aggressively when they are older end up exposing their savings to the unforgiving market volatility, which has the potential of eating into one’s savings, to the extent that they never recoup their losses.
Diversification is an approach to mitigate risk in your retirement investment portfolio through spreading investment out into various asset classes which include paper assets commodities real estate and so on. This is usually in an effort to minimize the long-term volatility that would affect the portfolio.
The levels of diversification
A well-diversified portfolio needs to be diversified at two levels, which are:
- Between asset categories, and
- Within asset categories
This implies that, beyond allocating your investment funds to stocks, or other paper assets such as bonds, you need to spread out the money further within the asset categories. Your main duty is to ensure that you identify the Investment segments of the asset categories, that will perform differently when subjected to different market conditions.
By doing this, you can hope that the result of any negative performance in a single investment will be counted by the positive performance of the other investment. Diversification is, as such, perceived as a way to potentially limit investors’ exposure to various asset classes.
The one thing to note, however, is that, as is the case with other investment strategies, diversification does not guarantee the absence of losses, or the presence of gains. Also, Investments that performed well during one economic downturn, may not necessarily perform in the same way during another economic downturn.
Diversification and correlation
Correlation happens to be a very essential concept in diversification, in that diversification will only work if the investment holdings are not positively correlated. Your investment holdings should move in different directions and should have different responses to the states of the market and economy. They should not be perfectly correlated (they should not rise or drop together, or in relation to each other).
Naive and optimal diversification
Individual investors who are not well versed with the computation of the correlation of assets often tend to use “naive diversification”. The technique can be advantageous if careful research is applied during the examination of each asset in the portfolio. Financial professionals on the other hand use the more sophisticated approach known as “optimal diversification”. With this approach, and assess the correlation of assets more effectively, to determine the right proportions of funds to allocate to various assets.
It is quite rare to find Investments that have perfect correlation, but it is common for them to have zero, low, or high correlation. A negative correlation indicates that the assets move in opposite directions at the same time when facing the same market conditions. This means that, the more Investments with zero or low correlation, the more diversified your portfolio is.
How to diversify your portfolio?
The first step towards the diversification of your portfolio involves the establishment of your asset allocation target, which is simply how you intend to split your investment funds between various assets. Since the ups and downs of the economy affect different investments in different ways, you should know that a strong year for stocks, will be accompanied by a weak year for the bond market, and vice versa.
This means that even if you’re investing for financial goals that are a couple of decades away, and you are quite comfortable with taking on risks in the process, it would be a good idea to keep a small portion of your investment portfolio in different Acids to help with the mitigation of losses of a bad year in say stocks. Some investors still prefer to have cash investments since they provide immediate liquidity when most needed.
Of late, it has become important for investors to put aside some money for use in gold investments, owing to the nature of gold as an asset, during economic downturns. The fact that the value of gold increases when the stock market is plunging makes it necessary for investors to consider adding a small percentage of this shiny metal to their retirement Investment Portfolio.
Diversification within asset classes
Once you are done with your asset allocation, you can proceed to diversify within the asset classes. In the stock portion of your portfolio, for example, you can consider investing in companies of different sizes, that produce different products, or across different industries and sectors.
You can also consider geography since the firms in different parts of the world are bound to have some unique economic trends which may lead to them generating higher returns in the years that the US stock market is performing poorly.
If you decide to go with bonds, there are several options that you can consider within the broad categories of government debt and corporate debt. The same applies to precious metal investments, where you can spread out your funds between different types of metals, or even different types of coins and bars. One thing to note, however, is that if you need liquidity when investing in precious metals through a gold IRA, you should hold coins instead of bars.
Are you ready to open a gold IRA today, to diversify your paper assets (stocks, bonds, ETFs) portfolio? Below are highly recommended gold IRAs you should consider.
That will be all for this article on how you can diversify and protect your financial future. I hope you found it beneficial, and that you can now diversify your portfolio from a more informed point of view. Let me know if you have any questions with regards to diversification, also through the addition of gold and other precious metals to your retirement Investment Portfolio.
I wish you success,
Eric, investor and team member at Gold Retired!