One of the most important things to do when building a portfolio is to diversify. You don’t want to put all of your eggs into one basket because a single hole in that basket could leave you with an empty portfolio.
For example, if you put 100% of your money into Enron stock, you’d have been left with nothing when the company went under. If you put 10% of your money into each of 10 different companies, even a collapse as bad as Enron’s would only cost 10% of your portfolio. Diversifying further reduces the risk even more.
Diversify on Your Own
The most basic strategy for diversifying is buying shares in multiple companies, but there are more advanced strategies that you can use.
For example, some people aim to split their portfolio between stocks with different market capitalizations. Market capitalization measures the total value of all of a company’s shares. Large-cap companies — those worth the most — tend to have lower returns but lower volatility than small-cap companies. Holding a mixture of companies of different sizes lets you get exposure to the high-risk, high-reward of small-caps while getting some of the benefit of lower volatility large-caps.
Others diversify their portfolio by holding different types of investments. For example, you might build a portfolio that is 70% stocks and 30% bonds. Stock prices can be highly volatile but bonds tend to be more steady. A mix of stocks and bonds lets you get most of the benefit from strong markets, but reduces your losses during downturns.
Diversify with Mutual Funds
One of the easiest ways to build a diversified portfolio is to invest in mutual funds. Mutual funds pool money from multiple investors, then use that money to buy securities. A single mutual fund can hold hundreds or thousands of different stocks.
Investors can buy shares in the one mutual fund to get exposure to all of the stocks in that fund’s portfolio. Instead of having to keep track of 10, 20, or more companies that they hold in their portfolio, an individual investor only has to keep track of the mutual fund they invest in.
Mutual funds can use all sorts of different investing strategies. Some aim to track specific stock indexes, like the S&P 500 or the Russell 2000. Others hold shares in companies that operate in a specific industry, like health care or utilities. Some use an active trading strategy where the fund’s managers try to find good opportunities to buy and sell shares to beat the market.
Some mutual funds even hold a mix of stocks and bonds, or adjust their holding over time to reduce risk as time passes closer to a target date.
Mutual funds do charge a fee for their convenience and management services, but passively-managed funds tend to be quite inexpensive and the simplicity, diversification, and peace of mind they offer is worth the small cost.
Diversify with Robo-Advisors
One service that has grown popular recently is robo-advisory.
Robo-advisors are programs that invest on your behalf. When you sign up for a robo-advisory service through a company like Acorns, you’ll usually have to answer some questions about your investing goals, risk tolerance, and financial situation. The program uses that information to construct a portfolio for you.
Once the robo-advisor builds a portfolio, all you have to do is deposit and withdraw funds as needed. The software handles all of the day-to-day for you, such as buying and selling shares or rebalancing your portfolio if one asset class outperforms or underperforms the rest of your portfolio.
Robo-advisors also offer other perks. A common one is tax-loss harvesting, which sells shares for a loss and reinvests the money in similar securities. This lets you deduct the paper losses from your income when filing your tax return, reducing your taxable income in the short term. Deferring those taxes to later can help increase the size of your portfolio.
Robo-advisors charge a fee for their service, typically as a percentage of your invested assets. Many claim that their benefits lead to higher returns that offset the fee, but it’s up to each individual to decide whether robo-advisors are right for you.
Pro tip: When the stock market is as volatile as it’s been, being diversified is crucial. Companies like Masterworks give you the ability to invest outside of the stock market. With Masterworks, you can invest in shares of fine art from some of the world’s most renowned artists.