Invest smart: How to diversify your portfolio

The idea that the money you save today can grow with you over time is a pillar of modern personal finance. How to invest your money is a very important skill to learn, but this doesn’t mean you need to become a great stock picker to be successful. In fact, you can learn to use simple strategies that have historically proven to perform very well, while lowering your risk.

There are so many ways to invest your money. You could put it into stocks, bonds, mutual funds, exchange-traded funds (ETFs), real estate, commodities, or alternative investments. Different asset classes (like stocks, bonds, etc.) will offer you different advantages and disadvantages as part of your investment plan. Some might move up fast when times are good, others might give you reliable income and help protect you when the stock market isn’t doing so well.

Knowing how to diversify a portfolio with the right mix of assets has proven to be the key for many successful investment strategies. Portfolio diversification lowers your level of risk while helping you smooth out your path to your investment goals. And as we’ll discuss in this blog, diversification’s built-in rules can take the guesswork out of reaching your financial goals. 

What is a diversified portfolio, and how does having one help you?

Diversification means you spread your money across many different types of investment options. Just like there are benefits to diversifying your income, there are multiple benefits to diversifying your investments, including:

• Spreading out your overall risk: For example, if you spent all of your investment funds on one company’s stock and that company went out of business unexpectedly, you could lose all of the money you’ve worked for. But if you owned a stock portfolio that included 20 companies and one of them went out of business, you would just lose 5% of your money. 

• Weathering market volatility and downturns: Markets fluctuate. Sometimes they go up and sometimes they go down. Some assets historically perform better than others in market downturns. If you have assets within your mix of assets that perform differently in different phases of the market, your portfolio is likely to always have a bright spot. This can help you ride out downturns and means you might even have some profit to spend when things start turning around. 

• Higher returns: Believe it or not, many studies point to the fact that diversified portfolios do better over the long term than many other investment strategies. 

• Emotional well-being: Investing can be emotionally and psychologically hard to handle. Market volatility and fear of missing out (FOMO) on something good can lead investors to make poor investing decisions at just the wrong time. Spreading your money around allows you to be less emotionally attached to any one outcome, and that means you’ll likely make healthier financial decisions. 

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How to diversify your portfolio with non-correlated assets

When it comes to portfolio diversification, there are many different strategies you can use. The most important thing is that you spread your capital across multiple assets that are non-correlated. That means their asset prices aren’t directly linked. 

Diversifying into different industries and geographies

For example, if you invest your money in two companies that build houses, if the housing market heats up or cools down, it's likely both stocks will move similarly. These are very correlated assets. While buying two homebuilders is more diversified than buying one, it’s not the best diversification strategy to protect you in multiple market conditions.  

Instead, you want to find assets that represent different industries or that have other features that set them apart. Let’s say you believe office buildings in Arizona will do well, and you also see promise in Argentinian agriculture. You could buy units of a real estate investment trust (REIT) that manages office buildings in the southwest U.S. and find a company set to profit by helping Argentinian farmers grow more food. These two assets are in different industries and different geographic locations. They won’t be as likely to move together if one experiences a downturn. 

Don’t worry, you don’t have to understand Argentinian agriculture to be a good investor! 

Using stocks and bonds as diversification tools

The most classic example of uncorrelated assets is stocks and bonds. These two are not only different, but they usually move opposite of each other. When the economy is doing well, investors are likely to buy stocks and ignore bonds. On the other hand, bonds are thought of as a safe haven when the stock market is expected to do poorly. 

With the right asset allocation in each, you can take advantage of this phenomenon and potentially make higher returns overall. You may not make as much while stocks are going up, but you can more than make up for it when things turn south. 

A classic portfolio allocation is to put 60% of your money into stocks and 40% into bonds, but this can be personalized based on your risk profile and time horizon. Younger investors who are less risk-averse often choose to put a higher percentage of their money in stocks and less in bonds, while older, more risk-averse investors might err on the side of caution and put more into bonds, which can provide them with income. 

One of the most powerful and vital parts of a well-diversified portfolio strategy is rebalancing at regular intervals. Let’s talk about why rebalancing can help your portfolio perform better while helping you stick to your investing plan. 

How to rebalance your diversified portfolio

If you have a set asset allocation like putting 60% of your invested funds in stocks and 40% in bonds, you’ll sometimes need to rebalance. The reason is as one investment outperforms the other, your portfolio balance will no longer be 60/40. 

For example, let’s say you put $100 into the market, and you buy $60 worth of stocks and $40 worth of bonds. After a year you look at your portfolio and you realize the bonds are worth $38, but your stocks have gone up to $72. You now have a portfolio worth $110 that’s split 66/34 between stocks and bonds. To rebalance this, you would sell some stocks and use those funds to buy more bonds. 

Putting this rebalancing on a regular schedule (like annually or every six months) that you can do regardless of circumstances is a great way to take the emotion out of investing and be more successful. But there’s another benefit that might be even cooler. 

If you’ve ever heard the phrase “Buy low and sell high,” it’s built right into this strategy. You sold stocks at a higher price than you bought them for (you sold high) and you bought more bonds while they were cheaper (you bought low). 

Of course, it works the other way, too: When the stock market goes into a downturn and investors run to the safety of bonds, you can sell the bonds that you bought cheap to buy the stocks that have now come down in price. Over many years, this strategy can really add up. 

Tips for how to diversify your portfolio

The 60/40 stocks and bonds split is a classic strategy. But there are many more assets you may want to make a part of your investing strategy. 

• Domestic stocks: These refer to any stocks traded on exchanges in your country. So if you are in the U.S., these would be stocks traded on the New York Stock Exchange or the NASDAQ. 

• International stocks: These are stocks traded on foreign exchanges across the world. In U.S. markets, you can often find a financial product to gain exposure to international assets without having to navigate foreign markets. 

• Bonds and bond funds: These are like buying a company’s or a government's debt. When a company or country needs to borrow money, it can sell bonds. The bonds include a promise to pay back the buyers with a certain interest rate over time. 

• Mutual funds: These are managed funds that usually specialize in certain types of assets and share the profits with investors. In recent years, ETFs — another pooled investment asset — have gained favor over many mutual funds due to lower fees. 

• Exchange-traded funds (ETFs): These are usually passively managed funds that  build a basket of themed assets you can invest in. There are ETFs that represent the entire S&P 500 and others that are more niche, like just oil stocks. There are many of these on the market, and they can have different rules and tax implications you should understand before investing. 

• Real estate: Buying real estate as an investment is a classic way to build wealth. Not only can you take advantage of possible asset appreciation, which means the value of your investment increases over time, but you might even be able to rent out the property for income. 

• Alternative investments: More and more investors are exploring alternative assets like art, collectibles, and cryptocurrencies. In strong markets, these can gain a lot of attention. However, they can be risky, and the value of these investments could drop a lot. Making these a small part of your portfolio can help you take advantage of the upside without taking on too much risk. 

• Cash and cash equivalents: An often-overlooked part of any smart portfolio is holding cash, or being able to access liquidity. Cash doesn’t mean dollar bills in a piggy bank but refers to unused funds held in your investment account. Keeping some of your investment funds in “cash,” money markets, or short-term certificates of deposit can help you to be ready for opportunities when they arise.  

All of these assets have risks involved. Before investing in any of them, it's important to do your research. You could also hire a professional to help you with your portfolio management. Financial advisors can help explain how to diversify your portfolio in a way that makes sense for you. 

How to buy assets that may seem out of reach for beginners

As a beginning investor, you may look at the list of different investments and think some are out of reach for you. If you’re starting with a modest amount of capital, buying real estate, for instance, might seem like a stretch. However, modern markets have created many financial products to help you get exposure to what you’re interested in even without tons of capital. Just like buying a share of stock instead of the entire company, there is likely a fund or an ETF for any specific investment you can think of. 

Greenlight makes investing even more accessible though fractionalized shares so you can invest for as little as $1. 

Portfolio diversification helps investors manage risk.

No one knows for sure what’s going to happen in financial markets or what assets will perform best in the future. We can look at what has happened in the past as a guide, but past performance doesn’t guarantee future results. Learning how to diversify your portfolio allows you to take advantage of many market conditions. Building a well-diversified portfolio of assets that typically do well in different market conditions and rebalancing them regularly could help you succeed in uncertain markets. 

Greenlight helps kids and parents gain valuable investing and financial knowledge in a fun and interactive way. Through our Greenlight Max and Infinity plans, parents can help kids invest right on the app.

Disclaimer: This article does not serve as investment advice, and you should consult a financial advisor when investing.