Beginner’s Guide to Investing: Why You Should Diversify Your Investments
You should diversify your investments to increase your possibilities of better investment returns and decrease your overall portfolio risk.
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This is part three in a series of articles for beginner investors. The first two parts covered why you should invest, and types of investments. This article covers the importance of diversification in your investments.
Here are some basics to keep in mind when trying to maintain your financial health:
What Is an Investment Portfolio?
You’ll often hear people refer to their investment portfolio. This is the breakdown of the different ways you invest your money in order to reach your goals. Your portfolio will change throughout your investing career as your goals change.
When you first start investing, your portfolio will reflect the fact that you are able to take a long view and will include investments that may be more volatile. You have the time to wait out the market and allow your stocks to recover. If you are closer to retirement, you want to make sure your money stays put and possibly shows some modest growth. In that case, your portfolio will likely focus more on less risky and lower returning bonds. In short, your risk tolerance and time frame help determine the diversity of your portfolio.
For military members, diversification takes on an added dimension. Your TSP already provides built-in diversification through its core funds. The C, S and I funds give you exposure to large-cap domestic stocks, small-cap domestic stocks, and international stocks respectively. Adding a Roth IRA, real estate investments, or an annuity on top of your TSP and military pension creates a well-rounded, diversified retirement plan that draws from multiple income streams.
How to Assess Your Investment Risk Tolerance
Determining your risk tolerance is an important part of drawing up your investment portfolio. For those investors who are willing to watch their money go up and down with the instability of the market, a more aggressive portfolio, but still one that incorporates diversity, will give the possibility of higher returns while still maintaining some stability. Those who don’t have the stomach for rapid declines can go the more conservative route but still incorporate a few riskier investments that could pay out higher returns.
No matter what your risk tolerance is, however, it is imperative that you diversify your portfolio so that no one investment dominates. That allows both aggressive and risk-averse investors to enjoy stability and the potential for growth.
How to Diversify Your Investment Portfolio
True diversification means spreading your investments across multiple asset classes, different types of investments that tend to respond differently to market conditions. The major asset classes include:
- Stocks – ownership shares in companies that offer growth potential but come with higher volatility
- Bonds – debt instruments that provide more stable, predictable returns with lower risk than stocks
- Real estate – property investments or REITs that provide income and act as a hedge against inflation
- Cash equivalents – savings accounts, money market funds, and CDs that preserve capital with minimal risk
Spreading investments across these asset classes ensures that a downturn in one area does not devastate your entire portfolio. When stocks decline, bonds often hold steady or increase in value, providing a natural buffer against market volatility.
Geographic and Sector Diversification
Diversification also extends beyond asset classes. Investing across different geographic regions and different economic sectors such as technology, healthcare, energy, and consumer goods adds another layer of protection. When one sector or region underperforms, others may offset those losses.
For beginner investors, index funds and ETFs are one of the easiest ways to achieve broad diversification in a single investment. A total market index fund, for example, gives you exposure to hundreds or even thousands of companies across multiple sectors and geographies in one purchase.
Why There Are No Guaranteed Investment Returns
When it comes to investments, people will sometimes get dollar signs in their eyes and forget the most basic tenet of investing: diversify. If you ever come across a “can’t-fail” investment strategy, treat it with extreme skepticism. There is no such thing as a sure thing. Accepting some risk means that you know everything is above-board. The only real way to mitigate the inherent risk of investing is to diversify. Any other scheme is just that, a scheme.
