One of the most important rules when it comes to investing is to diversify your portfolio. This is also known as ‘asset allocation’ or diversification, meaning you are not betting on one horse. After all, we want to earn long-term money, even if there is an occasional losing horse in between.
But what exactly is this? And how can you ensure that your investments are well diversified so that you minimize risk and optimize return? And what is the most ideal distribution?
How should you diversify your portfolio?
There is no unequivocal answer to that. This has everything to do with your personal situation. How old are you? How much of a risk can you afford? What do you sleep well with? How quickly can you make up for any losses?
If you ask ten different investment gurus what the ideal distribution is, you will get ten different answers. There is no such thing as ‘one truth’ in investment land.
Thumb of rule
A thumb of rule is that the older you are, the more you invest in less volatile and risky products. The reason for this is that as you approach the age when you want to enjoy your invested capital, you want to make sure you minimize the risk that your capital decreases in value.
A maxim that is often used is that one should invest his or her age in bonds as a percentage. Suppose you are 30 years old, your portfolio should consist of 30% bonds, and 70% stocks. These do not have to be single stocks and bonds, but can also be ETFs consisting of stocks or bonds.
This too is not cast in stone, it is not that bonds are completely safe or risk-free. Whatever you invest in, it involves risk. But Dutch government bonds do have less risk than investing in bitcoins.
Many investors also invest a small portion of their portfolio in gold or other precious metals. This is seen as a safe haven should the economy collapse. In addition, cryptocurrencies are on the rise and you notice that investors also invest a small part of their portfolio in them. See module 8 for an explanation of cryptos.
Law of diminishing returns
There is this law of diminishing returns that shows how much you lower your risk with every stock you add to your portfolio. We talk about the risk of volatility. When spreading over eight stocks, you reduce the risk of an individual stock by 80%. With sixteen shares, it is 93%. Each additional share that you add to your portfolio only slightly reduces the risk. This is good to keep in mind, while sometimes even more diversification doesn’t lower the risk of your portfolio.
What does it mean to diversify?
In the world of investing, people speak of ‘diversification’ when it comes to diversifying your portfolio. Diversification is a technique used to combine different investments in one portfolio. The idea behind diversification is to avoid losses on your investment and get a higher return. While this tactic does not guarantee that your investments will not diminish in value, it poses a lower risk to your money should the stock market crash. Below we list a few ways to easily spread your investment portfolio.
Invest in a mix of ETFs and mutual funds
The great thing about investing in different ETFs and mutual funds is that you can easily adjust your portfolio. They generally offer more diversity than single stocks, an easy way to get started! It is logical that funds or ETFs offer more diversity, these products offer you a basket of products to invest in, instead of in 1 separate product. We will explain this in more detail in the modules on various investment products.
A good rule of thumb: invest in at least five different ETFs or funds so that you can diversify investments across different markets, products, and sectors.
Quality over quantity
The fact that you have a lot of investments does not mean that your portfolio is well diversified. Sometimes you see that people have a lot of ETFs, stocks or cryptocurrencies, but that says nothing about their possible success.
An example: if you invest in 5 comparable ETFs that all largely follow the US market, then you focus too much on 1 demographic area in terms of diversification. Or if you own 10 types of cryptos, but no other type of investment products (stocks, ETFs, funds) then your investment is also risky because you focus on 1 product – cryptos.
In the mix!
To achieve a good diversification to minimize your risk and maximize your profits, you prefer to invest your money in different products (stocks, bonds, real estate, etc.), different markets (America, Europe, etc.) in various industries (tech stocks, food sector, commodities, and more).
How to diversify yourself?
You can easily diversify your portfolio by investing in funds. Nowadays you can invest in very broadly diversified funds via easy to use NEO brokers, in accordance with a risk profile chosen by you. This is the easiest way and is sufficient to invest successfully in the long term.
Diversification: Keep it simple
As mentioned above, you can easily invest in a safe way in funds. Remember that to invest successfully for the long run, it is not necessary to invest in a variety of individual stocks. Investing in ETFs or funds may be sufficient for the longrun. What you want to invest in and what is sensible for you, depends very much on your own situation and your own goals.