When you’re learning about investment, you’ve probably already heard that it’s important to diversify your portfolio. Perhaps you’ve already implemented that advice and went ahead to create a diverse asset allocation. But is your portfolio really as diversified as you think?
In this article, we want to discuss what it means to diversify your portfolio, what factors to pay attention to and how changing the proportions has an influence on your risk. Have fun!
Diversified portfolio is a mixture of different assets
When diversification is mentioned, it’s almost always for the reason to decrease risk. A portfolio that consist of real estate, stocks, P2P and cash will likely show less reaction to changes in rules concerning real estate, than one that’s purely real estate.
This is because different assets have a different correlation to each other. A chart from Guggenheim Investments shows that for example, the stock market had a slightly to moderately negative correlation to currencies and even cash in the time period from January 2011 to December 2021.
So, when the general stock market rose, an investment in currencies lost in value and vice versa.
There are a number of different asset classes you can choose from when assembling your portfolio. Here are some to consider:
- Real estate
- Stocks
- Cash, also in different currencies
- Fixed income assets such as Bonds or P2P Lending
- Commodities
Which ones you invest in ultimately comes down to your preferences, knowledge and budget. For example, buying a house requires more capital than investing in stocks or P2P lending. However, where there is a will there’s a way and one way to participate in the real estate with less capital can be REITs.
Fixed income assets can also be a great addition to your portfolio. They are usually not the high performers like stocks can be, but on the other hand offer security and a steady stream of income. Especially in a crisis, this can be very favorable, as the stability and not riding the emotional rollercoaster of seeing your investments 15% in the plus and then 10% in the red is worth a lot to many investors.
The same sense of security can be offered by holding cash reserves. This can serve as easily accessible liquidity should you need it to pay some bills, minimize the risk of your investments in general, and even be used when markets are down to buy stocks and more on the cheap.
It makes sense to hold the reserves in the currency you’ll use the most, but diversifying into USD, GBP, CHF or other currencies might as well be worth it if you want to split up your eggs over more baskets.
Don’t forget geography
Another factor to take into account for proper diversification is geography. If rulesets change or other situations like the current war take place, the impact on a specific country or region is bigger than on other countries, and therefore the influence on assets from that region will likely react more strongly to the circumstances than assets from other countries and regions.
With stocks this could mean not just buying stocks from North America, but also Europe, Asia and more. An investment vehicle that could help with this are broadly diversified index funds.
If you have fixed income assets in the form of P2P loans, then you could pick not only loans from Spain and Estonia, but also Nordic countries or even African countries such as the Lendermarket loan originator QuickCheck offers.
This will give the diversification another boost and make it less vulnerable to single events. The same also applies to sectors. For example, going all in on tech is likely more risky than also investing in infrastructure, agriculture and mining.
Manage risk by adjusting proportions in the portfolio
Of course, it’s not just up to what’s in your portfolio, but also how the proportions are. If you have cash and stocks in your portfolio, then it could be 99% cash and 1% stocks (very low risk) or 99% stocks and 1% cash (high risk). Or anything in between. And as there are not just two asset classes, it becomes more complex.
As a general rule of thumb, when you’re looking to balance your portfolio, you could say that things that yield less returns carry less inherent risk. Examples are cash or low-interest bonds from countries like the USA or Germany. So, the bigger the weighting of these assets in your portfolio, the less risky it can be as a whole.
Other assets carry more risk, like stocks, P2P loans, real estate etc. A big factor is also your knowledge about these assets: How much do you know about the market, and how well can you assess its risk? If you’re a real estate agent, you’ll likely be much more informed about real estate investing and can better judge whether an object is worth investing in or not.
You’re still exposed to the risk of regulation changing, but compared to someone without any real estate knowledge, one could call your real estate investment less risky because you know what you’re doing.
So look at the following when balancing your portfolio:
- Cash and low-interest AAA bonds are less risky, the more of them are in your portfolio, the lower the risk, in general
- Consider your knowledge about a market. The more you deeply understand and know about it, the more educated decisions you can make, and your investment likely carries less risk
If you’re not a risk averse person and open to taking risk (take our test to find out), you can also balance the portfolio to achieve higher returns and beat inflation. In this article, five P2P experts share their valuable tips on the topic.
Bottom line
Diversification is a handy tool to lower the risk of your portfolio. By picking from various assets in different countries and regions, as well as making sure the proportions to each other reflect your ability to take risk, you can design a portfolio that’s ideally suited for you.
P2P loans can be an interesting choice to consider, as they offer a fixed interest rate and loan originators on Lendermarket have a Buyback Guarantee, which makes them buy back loans if they default and pay back the principal + outstanding interest.