The art of diversification: how to improve your trading portfolio
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Skilling Writers Team
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- Trading
- Education
Did you know that 58% of Americans invest in the stock market? And out of those who do, many have their investments concentrated in only a few stocks or sectors, leaving them vulnerable to market fluctuations and potential losses.
One of the fundamental principles you and every other investor need to understand is the art of diversification. A diversified portfolio can reduce risks, increase returns, and protect against market volatility.
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The importance and benefits of portfolio diversification
Portfolio diversification, as the term implies, involves diversifying your trading portfolio by investing in various assets.
As the saying goes, "Don't put all your eggs in one basket". Portfolio diversification is an essential element of any investment strategy as it helps investors cope with the risk and uncertainty of the ups and downs of the stock market.
A Harvard University study suggests that a well-diversified portfolio's return volatility is half that of traditional stock.
According to the study, “Being undiversified is very costly”. One of the critical benefits of diversifying your trading portfolio is that it allows you to distribute risk across multiple asset classes, thereby reducing the risk of losing all of your investments.
Another benefit of portfolio diversification is that it exposes investors to a large pool of other investment opportunities.
In other words, a diversified portfolio allows you the flexibility to take advantage of different market conditions.
If you're new to investing, portfolio diversification may help you to achieve your financial goals. Investing in a mix of assets can help you minimize your risk exposure.
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Key concepts and strategies for constructing a diverse trading portfolio
A Vanguard research paper suggests that a 60/40 split between stocks and bonds is generally a good starting point for many investors.
However, so much goes into building a trading portfolio apart from simply choosing how much to put in what - though that is significantly important.
When constructing a diverse portfolio, there are several key concepts and strategies to remember. Here are some important considerations:
1. Asset allocation: a balancing act
Asset allocation is deciding how to distribute your investments across different asset classes, such as stocks, bonds, and commodities.
Find the right balance of risk versus return. What are your investment goals? Are you investing for the short-term or the long-term? How much risk are you comfortable with?
The answers to these questions are vital in finding that perfect mix. However, asset allocation isn't limited to investing in different asset classes.
Diversifying your portfolio can also mean allocating your investments across several countries and regions.You may also allocate assets based on market conditions.
For example, investing in bonds may offer the opportunity for higher returns than stocks during periods of high market volatility.
2. Understanding your risk tolerance
Risk tolerance is how much risk you’re comfortable taking on. High-risk investments offer a chance for higher returns, but they also put your money at greater risk.
On the other hand, low-risk investments will generally net you lower returns for the lower risk you're taking on. When constructing a portfolio, you must consider one's risk tolerance.
Suppose you're a younger investor with a longer investment horizon. In that case, you can afford to take on riskier investments, as you have more time to ride out short-term market volatility.
However, suppose you're an older investor with a shorter investment horizon. In that case, you may consider preserving your capital rather than gambling away your earnings.
3. Correlation: when one thing goes up, something else must go down
Correlation measures how closely two investments move in relation to each other. A great example of this concept is the relationship between the prices of gold and silver.
Investments with a high degree of correlation tend to move in the same direction. When one goes up, the other moves up, and vice versa.
An important strategy is to diversify across different sectors of the economy, such as agriculture, technology, finance, healthcare, and energy.
For example, the technology-heavy US100 Composite Index suffered significant losses as opposed to the S&P Healthcare Index when the dot-com bubble burst in the early 2000s.
You can reduce overall risk and increase diversification by including investments with low correlation, such as between stocks and bonds, in your trading portfolio.
4. Rebalancing (Again and Again)
Rebalancing refers to periodically reviewing your trading portfolio and adjusting the weightings of different assets.
The objective of rebalancing your portfolio is to maintain a desired allocation of assets by selling off ones that have done well and investing in ones that have performed poorly.
According to the Vanguard research paper, a rebalanced 60/40 stock/bond portfolio performed marginally better than an unbalanced portfolio in terms of risk and return.
Periodically rebalancing your portfolio can help ensure it remains diversified and aligned with your specific investment goals.
Skilling Summary
There's no magic formula to success. No one can determine how the market will play out. However, you can prepare your portfolio to handle whatever comes its way by using some concepts and strategies.
By diversifying your portfolio, you give yourself flexibility and security - which are even more valuable assets.
That being said, improving your trading portfolio will require discipline, patience, and (of course) commitment.
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Not investment advice. Past performance does not guarantee or predict future performance.
