Diversification is an important part of any investment plan and it ultimately involves acknowledging the fact that the future is uncertain and nobody knows exactly what will happen. If you knew what the future holds, there would be no need for diversifying your investments.

If you diversify your portfolio, however, you can smooth out the inescapable highs and lows of investing, increasing your chances of sticking to your original investment plan and perhaps even earning higher returns.

Here are some key tips to keep in mind to help with portfolio diversification:

1. It Isn’t Just Stocks Vs. Bonds

Whenever most people think about a diversified investment portfolio, what comes to mind is some combination of stocks and bonds. Financial advisors have gauged diversification and managed risk in a portfolio using the ratio of stocks to bonds for decades. However, that isn’t the only way to think about diversification. For example, fundamentals in Asia remain positive.

Portfolios can, over time, gain outsized exposure to certain classes of assets or even certain sectors and industries in the economy. Investors that owned a seemingly diversified portfolio comprising of tech stocks towards the late 1990’s were not actually diversified since the underlying businesses that they owned were all tied to the same factors and trends.

The Nasdaq Composite Index that mostly tracks technology stocks, fell close to 80% from its peak in March 2000 to its low in the fall of 2002.

Always ensure that you think about the sectors and industries that you have exposure to in your portfolio. If a certain area is carrying an oversized weighting, you should trim it back to ensure proper diversification across the entire portfolio.

2. Boost Your Diversification Using Index Funds

Index funds can be an excellent way to achieve a diversified portfolio without breaking the bank. Buying ETFs or mutual funds tracking broad indexes like the S&P 500 let you buy into a portfolio for close to nothing. This approach is easier than attempting to build a portfolio from scratch and monitoring the industries and companies you have exposure to.

If you prefer to take a more hands-on approach, you can use index funds to increase your exposure to certain sectors or industries you may be underweight. Such funds can be more expensive than those that track the most popular indexes, but if you would like to take a slightly more active approach to portfolio management, they can be a great way to gain exposure to various sectors.

3. Don’t Forget About Cash

Cash is usually an overlooked aspect of building a portfolio that comes with certain benefits. While it is almost certain that cash loses value over time because of inflation, it provides protection in case of a market downturn. Depending on the amount of cash in your portfolio and other investments held, it could end up helping your portfolio decline less than the market average in a downturn.

Cash also gives holders optionality. This means that the value is not just from holding the cash itself, but rather the options it gives you when the environment in the future is different from that of today. 

People often think of the currently available investment opportunities and ignore what could be available in the future. When you hold cash in your portfolio, however, you will be in a better position to take advantage of any future investment bargains when the next downturn in the market comes. Listen to our latest podcast on investing.

4. Target-Date Funds Can Make Things Easier

Investing in target-date mutual funds is another great way to maintain a diversified portfolio. These funds let you pick a future date as your investment goal, which is usually retirement. 

When you are far from reaching that goal, the fund will invest in assets that are relatively riskier such as stocks and then changes the allocation of the portfolio towards safer assets such as cash or bonds as you get closer to your goal. 

You will want to understand how the fund is investing, but target-date funds can be ideal for those looking for more of a “set and forget” approach.

5. Stay on Track with Periodic Rebalancing

The size of the holdings in your portfolio will change over time based on the performance of the investment. Holdings that record strong performance will form a greater portion of the overall portfolio while the worst performing holdings will see a decline in their weight. 

To maintain a diversified portfolio, however, you should occasionally rebalance the portfolio to the appropriate weight for each investment. You likely won’t have to do this more often than quarterly, but you definitely should check on things at least twice each year.

Following the strong performance of certain stocks such as Nvidia and Tesla, along with other assets such as cryptocurrencies, investors may find that those holdings account for a larger percentage of their portfolio than what would normally make sense.

Holding all, or a significant portion, of your investments in a single stock may lead to massive gains, but you could end up exposing yourself to a lot of risk doing so.

6. Think Global When It Comes to Investment

The U.S. offers so many different investment options, that it can be easy to forget about the rest of the world. In a global economy, however, there are increasingly attractive opportunities outside a country’s borders.

If your portfolio is solely focused on the United States, it can be a good idea to look into funds focused on Europe or emerging markets. As countries such as China continue growing at faster rates compared to the U.S., companies based there may benefit.

It can also be a way to protect yourself better from negative events that may impact the United States exclusively. Other markets might not suffer as much if there was an economic slowdown in the United States. Obviously, the reverse is also true.

Emerging markets face challenges sometimes because of their underdeveloped financial markets and economies that can cause bumps on their long-term growth trajectory. Portfolio diversification, however, is about smoothing the inescapable bumps regardless of where they come from.

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