There are several overriding truisms in the investment world, and one of them is truer than any other – Don’t put all your eggs in one basket. Although easier than it sounds, investors are subject to the greed and deliciousness that quick riches can get them. And they go and pour their entire life savings based on the hope that they can change their lives financially. For example, this user on Reddit took out a mortgage to buy Bitcoin at the peak of last year. As a result, he’s now in the hole for over 3 years. He basically borrowed from future time just in case he could get rich. This is a clear example of why yo need to diversify your portfolio.
How should you diversify your portfolio?
There is no one right answer. Most retail investors stick their money into index funds. This simple action alone is enough to have a diversified portfolio. Because these funds hold hundreds of stocks within their basket. However, if you prefer to hold individual stocks instead, The Motley Fool suggests a portfolio of between 20 and 40 stocks. Be careful as it is possible to over-diversify.
Additionally, I would note that between 15-20 stocks is when you get the most diversification benefits.
Diversification doesn’t just stop at individual stocks. You can also diversify across different sectors, industries, countries, and brokerage accounts. Yes I also include brokerage accounts. The SIPC insures your investments up to $500,000 if the brokerage firm goes bankrupt. Only $250,000 can be in cash. However if you have $250,000 sitting around in cash, then you’re probably not optimized. But in the case that a brokerage does go bankrupt, it doesn’t hurt to have multiple brokerage accounts. Each account will have the $500,000 SIPC protection. Although, I welcome that day when I can’t find enough brokerage accounts to store all my money. That sounds like a good problem to have.
Additionally, you can also invest in alternative investments in order to help diversify your portfolio even more.
Diversify Your Portfolio With Alternative investments
Real Estate Property
Investing in real estate can be tremendous work but at the same time provide a stream of cash flow. If you are considering investing in real estate, you need to be very aware of the local market, overall housing trends, mortgage opportunities, and any number of collateral costs. Real estate can also act as an inflation hedge which helps diversify your portfolio. House prices will fluctuate with interest rates.
Government and municipal bonds are considered risk-free investments, in the sense of default risk. Combining bonds with equities to diversify your portfolio has academically provided the most optimal result. If I were near retirement, I would mostly buy these. Especially if we ever see bonds as high as 5% again.
Also known as Foreign Exchange, or investing in foreign currencies. This is more of a speculative trade than an investment. As investors speculate how interest rates are globally impacted and shift their cash. For example, if you think US is doing terrible and the dollar value will go down, you might move your cash over seas. And think about an alternative like the Euro. Or perhaps the Swiss Franc.
When you’re rich enough to start thinking about hedge funds to diversify your portfolio, you’re in a good place. Although they have high fees, hedge funds do provide diversification that you can’t find anywhere else. With their ability to invest in private companies and startups, this is a big alternative to the traditional investments. Additionally, you can find hedge funds that invest in commodities and future. Also, you can invest in a basket of hedge funds called a fund of funds. However, this probably has the highest fees out of any other investment.
The good old saying is that cash is king. No allocation is complete unless you diversify your portfolio with a little bit of cash allocation. This is to safeguard against liquidity events. Or if a great investment comes around and you’d like to purchase some stocks for it. Unfortunately, if there’s inflation, holding cash is a loss. Even sticking it in a savings account with interest may not keep up with inflation.
Diversify Your Portfolio Conclusion
In conclusion, there are hundreds of different ways to diversify your portfolio. The most common and least laborious involve buying index funds. Buying and holding for the long term has served many investors well. There are both stock index funds and bond index funds. If you follow the lazy portfolio route, you can buy three of these. Then set it and forget it. The fund managers will take care of the investments in the fund. In return for a small management fee of course. This is noted in the expense ratio which you’ll find in the prospectus.