When a market is booming, there’s almost no chance of selling an asset at a loss. But then, we cannot forget about bear markets, and portfolio diversification becomes the hedge when one market is performing poorly.
As the saying goes, “never put all your eggs in one basket.” It becomes smart to leverage multiple investment opportunities so you can sleep soundly during unpredictable times.
But before diversifying your portfolio, there are questions you need to ask to ensure you make well-informed decisions.
Here are crucial questions every investor needs to ask about diversification before stepping into these new waters.
1. What’s your risk tolerance?
Risk reduction is a key essence of portfolio diversification. You’re putting your money into different assets in order to reduce your risks when one investment gets hit severely. For example, If your stocks stay constant or drop in value, you can look towards your other assets, such as real estate, which may be doing well at that same time.
However, it’s worthy to note that it’s impossible to eliminate risk totally from any investment. No investment offers a 100% guarantee of appreciating constantly. So, even when you’re trying to reduce risks, it’s imperative you determine the amount of volatility of the new investment you’re considering to know if it’s what you’re comfortable with.
Furthermore, you want to be sure you can handle the impact when your new and existing assets crash or stagnate simultaneously. That often means having enough equity or hard cash on the sides.
Notably, there’s no one true path to calculating risk tolerance. Although it typically changes with your age, goals, and net worth, your personal preferences also come into play.
In short, the total risk level of your entire diversified portfolio should be in sync with your personal risk tolerance.
2. What’s your risk-adjusted return on investment?
Having understood and established your risk tolerance, you want to determine your highest possible returns based on that risk level.
Typically, higher risk levels often offer the greatest returns. And your goal as an investor is to make the most of every investment opportunity.
There’s a way to calculate your risk-adjusted ROI so you know how much you’re being compensated for the risk you’re taking on. You can also use the efficient frontier model to calculate this.
3. How diversified is your portfolio within an asset class?
Before going into other entirely different investment opportunities, it’s advisable to first diversify within your existing asset class.
A well-diversified portfolio will have multiple assets within one asset class. Think exchange-traded funds, index funds — which usually contain a myriad of stocks — and real estate diversification.
For example, you may already be into residential real estate. While thinking of going into oil or corporate bonds, it’s smart also to buy commercial property to diversify within your existing asset class.
There are many technology-driven platforms that now allow investors of all net worth access to different real estate investment opportunities based on property type, location, etc. This offers investors exposure not only to alternative assets but to diversification within the same assets class.
4. How many asset classes are present in your portfolio?
Many investors look towards stocks and bonds, but a mix of these two assets doesn’t profer true diversification. Although they’re different, stocks and bonds do have some relationship and may be affected similarly.
To reduce your risk, it’s best to invest in different asset classes with very little or no correlation. This will ensure that your investments do not get affected the same way when something bad happens in one market.
So if you’re already into stocks and bonds, now’s the time to break into real estate and buy commercial property. Since investing in commercial real estate requires more sophistication, you want to ensure you have the support to make the process as smooth and efficient as possible.
The different return structures, investment horizons, and risk levels of the different asset classes reduce correlation and volatility within your portfolio. The chances that your entire portfolio will be hit at the same time drops dramatically.
5. Will the new investment add value to your portfolio?
Although risk mitigation is a key essence of portfolio diversification, it’s not the only one: value matters too.
So ask yourself, “How much value does the new investment opportunity offer to my overall portfolio?”
Notably, the value an investment offers to a portfolio often depends on its correlation with other assets in the portfolio. There is maximum value when each asset shares little or no correlation with the other classes. You do not want the prices of all your assets to increase in unison, as that means they are also likely to crash simultaneously.
But while you may think assets are unrelated, they, in fact, maybe. For example, an increase in gas prices may impact the same risks to an airline company, a car rental service, and any other business that may require fuel in its daily operations.
Since they all require the same resources, they’re related even when their overall risks and structures are entirely different.
One way to hedge against this and add considerable value to your portfolio is to go into the private and public markets.
Avoid focusing on the public sector alone. The same applies to the private.
While public investments are considered more efficient, they have higher volatility and correlation.
On the other hand, private sector investments are less correlated. So you’d be benefiting from both worlds as investment from each market complements the other. Your portfolio’s overall correlation and volatility is reduced, thereby increasing its ultimate value.
6. Are you considering inflation?
While you may think your assets appreciate over time, they may actually only maintain the same purchasing power.
For instance, a $10,000 asset may be worth $13,000 after some years, but inflation rose 30% during that time. What that asset could buy before is what it can buy now. That means you actually didn’t make a profit.
Luckily, investing in hard assets like real estate is one of the best ways to hedge against inflation. You receive rental income periodically as the property increases in value over time.
Finally, you want to ensure you’re being strategic with your diversification. Do not diversify for the sake of diversifying; if you do so, chances are you wouldn’t take correlation and these other things into account.
Get analysis on your investment portfolio so you can eliminate correlation and attain proper diversification. If you feel it’s beyond you, it’s always best to seek professional help.