In financial investing, diversification refers to the purchasing of a range of different securities to reduce exposure to any one particular asset or risk. The most common form of portfolio diversification is investing in different asset classes whose returns have a low correlation. The benefits of diversification have been proven by numerous studies. In fact, a well-diversified portfolio tends to generate the same returns as a non-diversified portfolio but carries a much lower level of risk.
Diversification is often referred to as ‘the only free lunch’ on Wall Street. On Wall Street, there is the expression ‘there is no such thing as a free lunch’, which means if someone is inviting you out to lunch they will want something from you in return. However, diversification is considered to be a ‘free lunch’ as portfolio diversification leads to reduced risk but with the same expected returns.
How to Diversify Your Investment Portfolio
The key to diversification is to invest in a range of assets than have a low correlation with one another. However, you also need to be careful that you do not over-diversify, as this will negatively affect your portfolio returns in the long run.
The core of your investment portfolio will most likely consist of stocks and bonds. The most basic way to diversify these investments is to buy the right mix of stocks and bonds for your risk-return profile. Whether that is 75% stocks and 25% bonds or an even split. The key is to reduce volatility while not giving up on returns.
To diversify further, you can add real estate, precious metals (such as gold and silver), derivatives, and peer-to-peer loans to your portfolio.
Investing in Alternative Asset Classes
The simplest way to invest in alternative asset classes such as real estate, gold, silver, oil, etc. is through the use of ETFs. ETFs are exchange-traded funds that replicate the performance of an underlying asset and are tradable on exchanges just like a stock. That way you can gain exposure to commodities, without needing to physically purchase them, and entire real estate sectors without ever needing to purchase a physical property. To invest in real estate you could also buy REITs (Real Estate Investment Trusts), which are funds that invest in properties and are traded on the stock exchange and are somewhat similar to holding an ETF.
The same goes for stocks and bonds. Instead of investing in individual stocks and bonds, for which you will incur trading fees, you can invest in ETFs that track specific stock and bond markets, such as an S&P500 US Stocks Index ETF or an MSCI World Bond Index ETF.
Investing in Derivatives
In the derivatives space, binary trading is a popular option as binary options allow you to bet on an underlying asset either closing up or down after a pre-determined time horizon. This can be useful for hedging certain trades but also to put on intra-day trades to capitalize on sharp market movements.
Peer-to-Peer Loan Investments
Moreover, peer-to-peer loans are a great diversifier and an excellent way to boost your returns. Peer-to-peer loans are loans to start-ups, SMEs and individuals and can be invested in via online crowdfunding platforms, such as Lending Club and Prosper. As peer-to-peer loans are uncorrelated with stocks and bonds, they have become a new ‘must-own’ diversifier for any broadly invested portfolio. As they are riskier than traditional fixed income securities, such as government bonds and corporate bonds, they also offer higher returns for investors.
More Esoteric Diversification
If you want take diversification further, you could also invest in more esoteric alternative asset classes such as collectibles, which would include fine wine, art and antiques for example, or you could invest in early-stage start-ups through the use of equity crowdfunding platforms.