When you’re putting your money aside and gathering info on how to do so, you’ll likely come across the term “Diversification”. But what is diversification, and how to diversify a portfolio?
On this page, we’ll explain everything you need to know about diversification, how it influences returns and what experts recommend to assure a diversified investment.
Here’s an example to highlight the importance of diversification: Say, you invest all your money into Tesla stock so that your portfolio only consists of this single position. If the stock rises, then your portfolio value rises as well, however if the stock plummets, then your portfolio will be in the deep red.
This can be risky because you’re only reliant on the performance of a single company. If another company develops better tech, regulations change and make the work harder for Tesla or other issues reduce the trust in the company, then your net worth sinks without you being able to foresee and combat it.
On the other hand, with portfolio diversification and investing into different stocks, bonds, real estate and P2P loans, the influence of a single stock on your portfolio is softened. A natural disaster destroyed your rental property? That’s devastating, yet through the diversified investing approach it’s not 100% of your net worth that’s impacted.
Diversification is a risk management strategy, that also means it’s possible to utilize it to adjust your portfolio for returns, not just safety. It is a suitable strategy to use to implement assets that have higher returns and in turn can boost the average returns of your portfolio, while still keeping the risk at hand.
Cryptocurrencies are a highly volatile asset that many investors judge as too risky for their liking. If your portfolio consisted solely of cryptocurrencies, it would be highly volatile. So, what if you want to reduce the volatility, but still try your hand at crypto?
You could allocate a small percentage of your portfolio to crypto, and put the rest in other assets. That way you still have the option to benefit from any rises of that asset, but on the other hand won’t decimate your portfolio if the investment fails.
To achieve a well diversified portfolio, there are a couple of components to consider. Here are the primary components of a diversified portfolio:
Diversifying by mixing different assets
The primary way to diversify your portfolio is by investing your money into different asset classes. This could be bonds, stocks, P2P Investments, real estate, cryptocurrencies, cash, retirement plans, items such as furniture, vehicles, or art.
The lower the correlation between each asset, the better in building a portfolio that can withstand varying markets being impacted and yet still staying strong.
When diversifying, it’s not only important to pick different asset classes, but also to buy assets from several countries. This is so your portfolio is less susceptible to changes in regulations or other events that majorly impact a single country.
An example could be you owning real estate solely in Japan and an earthquake destroys the houses, or you holding stock in Chinese companies and the Chinese government forbidding foreign investors to own shares of Chinese companies and restricting access to the Chinese stock market.
So make sure to spread your investment over a variety of different countries and regions.
Adjusting proportions in the portfolio
The ratio of each asset in your portfolio to each other has a big influence on the riskiness of your portfolio and the effectiveness of diversification. For example, stocks are, in general, a riskier asset than bonds. So, the higher the proportion of stocks in your portfolio in relation to the bonds, the more risk it carries.
On the other hand, the higher the weight of the less risky assets, the less risk your portfolio carries overall. To achieve as little exposure of a single asset to your portfolio, and therefore maximize diversification, one could have even shares for all their assets. If your portfolio consists of 5 different assets, then an example of a diversified portfolio could be each asset having 20% of the whole portfolio’s value.
When investing your money, whether employing diversification or not, there’s always the risk of losing money. Diversification can’t eliminate that risk. However, it can help you mitigate the risk by limiting your exposure to a single asset and putting your eggs in many baskets.
Before starting to invest your money into as many assets as possible in order to maximize diversification, ask yourself: What goal do I want to achieve with my investment? and How can diversification help me with that?
Perhaps you have a specific goal in mind that you want to reach, where investing money will aid you. On the other hand, you wish to limit the risk to a certain extent. If you decide that now is a good time to invest, then create a strategy on how to achieve that goal, and build a portfolio that supports your requirements. For beginner investors, erring on the side of caution is often a recommended strategy, as they have not yet experienced shifting markets and the emotional impact it has might trigger panic sales. If that holds true to you, giving the less risky assets in your portfolio more room might be a good choice. If you’re experienced and know how the ups and downs of the markets make you feel, then you might be fine with adjusting the portfolio to carry more risk. After all, creating an investment portfolio is a highly personal matter which is prone to change over time.
On Lendermarket, you can invest in P2P loans, which can be a good add-on to your portfolio. P2P loans are a type of fixed income investments, from which you will receive a steady cashflow, while still being able to generate high returns upwards of 10%.
Lendermarket allows you to invest into P2P loans of over 10 different countries, so no matter how the market in one country performs, there are many more to balance it out. You can not only invest in consumer loans, but also in real estate-backed business loans.
Furthermore, the loans on Lendermarket have a buyback guarantee, which means that if the debtor defaults the loan originator issuing the loans will buy back the loan from the platform, and pay you back any principal plus outstanding interest.
We have strict due diligence and monitoring of our loan originators to make sure they’re able to fulfill their duties.
That’s why P2P loans on Lendermarket can be a good addition to a portfolio to enhance the diversification of it.