Diversification is something that all investors want to
achieve to spare themselves from a bearish swipe. Here are some of the most
useful tips for diversifying your portfolio.
Understand Your Risk Tolerance
Risk tolerance is a measure of an investor’s appetite to
take on and endure risk. It’s your ability to withstand volatility in the marketplace
without making any emotional or heat-of-the-moment investment decisions.
Individual risk tolerance is usually influenced by factors
like age, investment experience, and various life circumstances.
Your own risk tolerance can definitely change over time. Certain
life events can affect your ability to endure market volatility. You should
promptly think about these changes in your portfolio risk profile as they take
place.
Understand Your Risk Capacity
Usually your emotional willingness and actual capacity to
take on risk can be contradicting each other. You may want to take more risk
than you can afford. On the other hand, you can be way too conservative while
need to be a bit more aggressive.
Factors like the size of your services and investment
assets, investment horizon, and financial goals will determine the individual
risk capacity.
Set a Target Asset Allocation
Attaining the right balance between your financial goals and
risk tolerance will determine the target investment mix of your portfolio. Usually,
investors with higher risk tolerance will invest in assets with a higher risk-return
profile.
These asset classes usually include small-cap, deep value,
and emerging market stocks, high-yield bonds, REITs, commodities, and various hedge
fund and private equity strategies.
Investors who have lower risk tolerance will look for safer
investments like government and corporate bonds, dividends, and low volatility
stocks.
In order to achieve the highest benefit from diversification,
investors must allocate a portion of their portfolio to uncorrelated asset
classes. These investments have a historically low dependence on each other’s
level of return.
For classic examples, the US large cap stocks and US Treasury
bonds have a negative correlation of -0.21. In simple words, they move in
opposite directions.
US Treasuries are considered a safety net during bear markets
while large cap stocks are best during strong bull markets.
Decrease Concentrated Positions
There’s a high possibility that you have an established
investment portfolio. If you own a security that represents more than 5 percent
of your whole portfolio, that means you have a concentrated position.
The risk of having a concentrated position is that it can
drag your portfolio down significantly if the investment has a bad year or the
company has a broken business model. As a result, you can lose a huge portion
of your investments and retirement savings.
Managing concentrated positions can be complex. Usually,
they have restrictions on insider trading.
Rebalance on a Regular Basis
Portfolio rebalancing refers to the process of re-calibrating
your portfolio back to your original target asset allocation. Since your investments
grow at different rates they will start to deviate from their original target allocation.
Bear in mind that this is very normal. There are times when
an investment can have a long run until they become very overweight. There are
also times when they can have a losing streak and become significantly underweight.
Rebalancing regularly can help you ensure that your
portfolio of investments is still in line with your investing goals and risk
tolerance.
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