Thinking about diversification? Here’s how to do it without risking your finances
If you ask any senior investor about the key to financial security in retirement, they’re bound to share one strategy: portfolio diversification.
Few practices have gotten more buzz in recent years and it seems that diversification is the lifehack of the modern investor. From young millennials working in tech to Wall Street magnates, everyone praises diversification as the go-to way to mitigate investment risks and boost wealth. However, approaching it without knowing what you’re doing and without balance can have a negative impact on your finances. There is such a thing as over-diversification and when you’re just starting out with investments, it’s easy to get carried away and lose your focus.
So, how do you reach that perfect balance required to boost personal wealth during retirement?
First of all, let’s go over what diversification means. Diversifying your portfolio implies mixing different asset classes and investment vehicles within a portfolio so that you can limit your exposure to a single risk. Thus, if acertain industry takes a blow or one asset drops in value, you don’t risk losing everything. Although anyone can try diversification, experts recommend it especially for long-term investments, such as retirement accounts.
In the UK, life expectancy has stabilised at 79.2 years for men and 82.9 years for women. Moreover, the number of people older than 90 has doubled in the past years. A longer life is, of course, a reason to be happy, but it also calls for more careful financial planning. After all, in order to have a stress-free, independent life, your retirement savings need to last longer. And through diversification, you can do that. According to a study conducted by ASFA/State Street Global Advisors, people who invested more than 75% of their money in cash and traditional asset classes could expect their retirement savings to last until they turned 90. And that sounds pretty good but the study also found that people who invested only half of their money in cash assets and the rest in shares, bonds, and other alternative investments, could expect their retirement funds to last until they’re 98.
However, diversification just for the sake of it does more harm than good and if you don’t know how to approach this strategy, you might expose yourself to more risk. Here are the key considerations to keep in mind for successful diversification in the long run.
Learn to limit your holdings
The common consensus among investors is that you don’t need more than 30 stocks to diversify your portfolio. And even that number can be too high. In general, you should strive to have about 20 stocks, in the beginning at least. Having an unreasonable amount of holdings is one of the biggest mistakes in portfolio diversification because you won’t have time to understand and monitor every one of them. Experts recommend that you shouldn’t obsess over how many stocks you hold. Instead, focus on their quality and diversity and you’re more likely to see positive results in the long run.
Do your research and only invest in industries you understand
This tip applies especially to investors who love investing in foreign stocks. Although they can be very profitable, they come with a huge challenge: for long term success, you need to pay attention to the evolution of overseas economies. Sure, the companies in Standard & Poor’s get about half their revenue from foreign stocks, but that’s because they have insights into these markets, the kind of insights that an individual investor doesn’t. Charlie Munger, vice chairman of Berkshire Hathaway and Warren Buffett’s business partner even said in a recent interview that there’s a lot of trouble waiting for investors who rush to invest in foreign markets, especially China, without understanding their economies. The same goes for trading currencies on the Forex market. For long-term success, you shouldn’t just check the rating of a Forex broker, but also understand how social, economic, and political events influence currency pairs.
As for investing in new technologies and the so-called “disruptive” industries, Warren Buffet himself advises taking everything with a grain of salt. In the age of ICOs and overhyped articles in the media, every new industry and promising start-up is labelled as the next big investment opportunity and the best option for people who want to diversify this portfolio. However, as a responsible investor, you need to look beyond the hype and base your decisions only on data (and the opinion of a professional advisor, if possible). To avoid unpleasant surprises, diversify your portfolio by investing in assets you understand. You can always expand your options later and keep adding to your portfolio, but at your own pace. Knowing the industry well also makes you a better investor because you’ll be less likely to react rashly to negative news.
Diversify asset classes to mitigate risks even further
One of the things that people often get wrong about diversification is that numbers alone don’t make a good portfolio. You could own 20 stocks, for instance, but if all of them belong to companies of the same size, in the same region, in the same industry, then doesn’t mitigate risks too much. Instead, consider diversifying asset classes even further by investing in companies of various sizes, on different markets, and even in industries that are not correlated with each other, as long as you understand them. This way, if one sector of the economy takes a hit and triggers a domino effect, you don’t risk losing everything.
Last, but not least, keep this disclaimer in mind: no investment strategy is 100% risk-free. As safe as it may be when done right, diversification cannot protect you against threats such as political instability and inflation.
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