A good number of people miss out on the wealth-building benefits of investing because of the associated risks. To them, investing is like staking their hard-earned money in a game of blackjack.
The current economic downturn only seems to prove them right. Equity markets around the world are nosediving, leaving investors scrambling for fast liquidity and safe-havens for their hard-earned cash.
Investing can be risky, of course, but there are time-tested strategies to hedge against risk and protect your funds. Diversification is the process of spreading investments across various instruments, sectors, and other categories to reduce risk. The idea is to invest in different areas that won’t react the same way to an unfavorable event.
Although it doesn’t totally eliminate risks, diversifying your investment portfolio is the best way to reach your long-term financial goals while keeping your risks to a minimum.
Let’s dig into the reasons why it’s essential to diversify your portfolio and how best to go about it.
Step 1: Understand the need for diversification
The chief argument for diversification is risk reduction. There is a degree of uncertainty in every financial market; hence you risk losing it all if you put all your money in one company’s shares. In the same way, you could lose money if you invest it all in one asset class – say real estate or equity in a single business. An adverse event, such as the housing crisis of 2008, will leave you with nothing.
Fortunately, all markets cannot crash at the same time and in the same manner. Therein lies the straightforward beauty of diversification. When you spread your investments across different companies and different investment classes, you reduce the effect an isolated catastrophe will have on your portfolio.
Step 2: Balance your risk-return appetite
Before you rush to buy into any financial product, lured by promises of fantastic returns, also bear in mind that the investment is likely high risk. In other words, to make high returns, be ready to carry high risk. The higher-than-average returns on your investment are the reward for taking on high volatility. Therefore, before investing, it’s crucial you know the amount of risk you’re capable of taking to give the commensurate returns
Take your time to balance your appetite for returns with the possible risks. Making investment decisions based on careful consideration of the levels of risks and returns ensures you’ll enjoy higher returns in the long term. For instance, stocks offer some of the highest levels of returns, and hence, are attractive to investors. However, investors who put all their money in stocks prior to the spectacular market crashes of 1929, 1987, and 2009 must have learned the bitter lesson that investing in stocks alone is not a sound financial strategy.
Step 3: Keep an emergency cash reserve
According to experts, you should keep some cash as an emergency fund to cover living expenses for a minimum of six months. This emergency cash reserve may be domiciled in your bank account, or if you choose to invest it, in a money market account, certificate of deposits, or similar alternatives.
An emergency cash reserve will see you through tough times without having to liquidate your assets. Force-selling your assets at the wrong time could mean more taxes and lower returns, and this at a time you desperately need money.
Another reason – mostly used by wealthy investors – to keep cash is to use it to buy up assets when the economy tanks. They keep the money to exploit opportunities such as those that arise in a financial crisis when assets can be bought cheaply.
Finally, including cash in your portfolio gives you a liquidity reserve you can draw on when the stock markets close for extended periods. These are situations where it won’t even be possible to liquidate assets.
As a rule-of-thumb, you should allocate no less than 5% of your portfolio to cash. Some experts say that 10 – 20%, at a minimum, will give you the best risk/return trade-off.
Step 4: Consider ETFs over single stocks
A single stock has varying risks or volatility, which depends on the stock, the sector, the market, and the economy. An adverse event in the industry or market poses considerable risks to any holdings in the stock of a company in that industry.
On the other hand, ETFs are less risky because they consist of a bouquet of investments. In order words, they are already diversified. Depending on what is in the actual ETF, an unfavourable turn in the market is less likely to affect all the investments in the ETF the same way. However, bear in mind that expected rewards are lower with fewer risks.
Asides from being safer than individual stocks, ETFs can be bought and sold just like stocks, and they typically cost less in terms of fees.
Step 5: Step up your ETF game with All-in-One ETFs
An all-in-one ETF is made up of several “sub-ETFs” and provides an extensive portfolio of diverse assets in one ETF. It gives you more diversification – across markets in North America and emerging and developed international markets than a regular ETF. Furthermore, it offers you a broader portfolio, just like those provided by Robo-adviser, at a lower cost.
Investing in all-in-one ETFs also gives you the convenience of automatic rebalancing to ensure your portfolio maintains the desired investment objectives. It can be set-up for a specific investment goal, aligning with your risk appetite and tolerance. These investment objectives are classified under income, balanced, conservative, and growth. And much like regular ETFs and stocks, an all-in-one ETF can be traded on a stock exchange.
Step 6: Let a Robo advisor do the thinking
Robo-advisors are the AI equivalent of wealth managers. Powered by technology, they typically invest in low-cost ETFs. For a relatively small fee, they do all the heavy lifting for you, so you never have to bother about rebalancing or portfolio diversification. Investing with Robo-advisors is best for you if you want to optimize your portfolio but do not have the time or skills to actively manage them yourself.
Robo-advisors use technology to simplify and automate the investing process. When you open a new account with a Robo-advisor, you supply them with information regarding your investment objectives, risk tolerance, and time frame. You can modify these preferences at any time. The Robo-advisor then uses this information to profile your risk tolerance, figure out suitable asset allocation across the different instruments, and select a diversified portfolio. You can set up automatic contributions to your new account and start investing right away.
Step 7: Dip your toes in the real estate market
A well-diversified portfolio would be incomplete without real estate allocations. Investments in city real estate are resilient and have a track record of excellent performance in times of inflation. Time and again, the urban property market has recovered at record speeds, to the great benefit of its investors.
In general, real estate is uncorrelated to stocks and bonds and, therefore, does not move directly with them. When the economy is in trouble, no market is left untouched. However, bricks and mortar in Europe’s metropolises have historically offered a powerful hedge against a market downturn, as these appreciate in price over the long run.
If you are a risk-averse investor, allocating assets to real estate is ideal, especially during bear markets.
Luckily, anyone has the chance to become a property investor through the means of modern real estate crowdfunding. For small sums, you can lend money to real estate developers against fixed, double-digit annual returns. Another popular method is the buy-to-let model, where private individuals pool funds together to buy and rent out properties to tenants. This way, investors benefit from the increasing property value while receiving monthly rent payments.
Step 8: Rebalance your portfolio yearly
Portfolio rebalancing is the practice of adjusting the asset allocation of your portfolio to revert to your preferred portfolio mix, and ultimately, to your investment objectives.
To achieve a desired financial goal, you allocate assets accordingly, based on your risk tolerance, amongst the different investments that make up your portfolio. For example, if you’re in your early 30s and years from retirement, your asset allocation may tend towards riskier high yield investments.
With time, the pre-set balance of the different assets starts to change as their value increases or decreases. A particular stock may experience such high returns that it makes up a more substantial part of your total portfolio than you want.
It then becomes necessary to rebalance your portfolio by reallocating assets, returning them to their original mix.
Diversification is a formidable element of a sound investment strategy. You must consider how much risk you can tolerate and how much time you have before settling on the portfolio mix that will give you the desired outcomes.
This is a guest post contributed by Lucas P. of Ampleinvest.com, a review and comparison site for European investors