Many beginning investors hear that they need to add diversity to their portfolios. However, with all of the investment options available, it’s easy for confusion to set in when you want to diversify your portfolio.
The longer you look at your choices, the more complex everything appears. When everything starts to look too complicated to you, it’s time to take a deep breath and realize that there are some simple ways to diversify your investment portfolio:
Use index funds or ETFs
The first step to diversify your portfolio is to use index funds or index exchange-traded funds, or ETFs. These investments focus on a particular asset class or sector. You can invest in an all-market index fund or index ETF that owns a little bit of all the publicly traded companies in the United States.
It’s also possible to invest in index funds or ETFs that focus on smaller segments, such as clean energy stocks or small business stocks. You can also find index funds and index ETFs that follow bonds, so it’s possible to invest in a variety of bonds, just by purchasing shares in one fund.
Index funds and index ETFs make it easy to set up your portfolio diversification according to the principles of asset allocation put forth by Nobel Prize winner Harry Markowitz in a 1952 paper, and later expanded upon in a 1959 book.
This is the simplest way to diversify your portfolio for long-term investing. You don’t have to worry about stock picking with this method, and that’s a good thing. Markowitz pointed out that 90% of returns are due to asset allocation.
Since Markowitz’s time, a number of behavioral finance studies have been conducted. Almost all of them point to the idea that stock picking is a bad idea for most investors. If you want to keep things simple, stop thinking that you have to “beat the market.”
As Larry Swedroe points out in a Journal of Indexes article published in 2012, too many people think that they have superior intellect and can pick the right stocks and bonds to come out on top. The reality is that you are better of keeping it simple with index funds and ETFs.
Diversify your portfolio with REITs
After you’ve put together your basic portfolio using asset allocation with index funds and ETFs, you might want to diversify your portfolio a little more. Many people like adding real estate.
While it’s true that you can buy property outright, many people find the process complex and difficult. Additionally, it can be daunting for many beginning investors to raise the necessary capital for a real estate purchase.
A simpler way to add some real estate and diversify your portfolio is to include Real Estate Investment Trusts, or REITs. These investments work similarly to mutual funds and ETFs, in that you receive exposure to a variety of investments by purchasing shares in one REIT.
Other ways to diversify your portfolio
Don’t forget that you can diversify your portfolio across geographic locations as well. There are index funds and ETFs that follow foreign stock markets. You can also invest in funds and ETFs that follow foreign bonds.
This allows you to add geographic diversity to your portfolio, which can protect you to some degree if domestic markets have trouble during times when foreign markets are doing just fine.
You can also, if you have a little more wiggle room in your finances and you can handle the risk, purchase shares in commodity or currency ETFs to add extra asset diversity. There are even precious metal ETFs that can provide exposure to gold, silver and platinum if you are interested in those assets.
The bottom line, though, is that simple diversity works best. Use index funds and ETFs to get a good mix of stocks and bonds and diversify your portfolio, and then revisit your portfolio once a year or so to make sure that it’s still in line with your goals.
