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6 Portfolio Diversification Mistakes To Avoid
A diversified investment is a portfolio of various assets that may earn the highest return with the least risk. A typical diversified portfolio is a mixture of stocks, fixed income, and commodities. In a diversified portfolio, the assets do not correlate with each other. When the value of one rises, the value of the other falls. It lowers the overall risk because no matter what the economy does, some asset classes will benefit you. That offsets losses in the other assets. Diversification works because these assets will react differently to the same economic event. Risk is also reduced because it is rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is the best way to protect yourself against a financial crisis.
A diversified portfolio should contain the following:
- Stocks
- Bonds
- Mutual funds
- Insurance policies
- ETFs
- REITs
- And several others
We are all humans, and we make mistakes. But we can avoid these mistakes by spreading awareness. Let us take a look at the mistakes investors make when they diversify.
Too Many Investments
Keep your holdings down to a minimum and a manageable number of investments. Holding too many investments in the portfolio will dilute the benefits of diversification. Keep it between 20% and 30% of your entire investment. Buying stock in 20 discount retailers will not diversify your portfolio, but buying 20 stocks in different sectors and industries will diversify your portfolio. Having fewer investments means having an easier time making sense out of it.
Buying Illiquid and High-Fee Investments
Do not forget that individual stocks themselves often offer you an asset diversification that might not be found in Sector ETF. Stock movements are moved by underlying economic drivers. So, by owning a stock with an exposure to another type of asset, you are diversified into that other asset. For example, Suburban homes. Owners of KB Home- it is a company that has been making great money by selling houses to Texas Oil Workers who might be looking for other work now.
Buying Foreign Funds And Stocks
Many foreign-stock investments vehicles have performed poorly historically. If you own large U.S Stocks, you are already getting huge exposure to overseas economies. According to Standard & Poor’s, the companies in the S&P 500 index get about half their revenue from overseas markets. Their managements are paying much closer attention and getting far better insights into their overseas business interest.
Long-term Exposure To Commodities
Commodities are to be traded and not owned. Investors spot opportunities, and they do not feel compelled to be in all commodities all the time. Buying and holding these trading vehicles will not build your wealth over the long term. Therefore, invest for short-term goals only.
Assuming That Diversification Is A One Time Exercise
Your allocation to different asset classes will drift away from the original path over time as each investment will earn a different rate of return, which will skew the asset allocation. If you do not periodically rebalance the portfolio, then the allocation will no longer be what is suitable for your needs and goals. Look out at the allocation at a pre-fixed schedule and reallocate the funds to regain the original allocation so that your portfolio continues to be balanced and is on track to meet your goals.
Not Understanding The Investment
Do not buy stocks in companies if you do not understand their business models. The best way to avoid this is to build a diversified portfolio of Exchange-Traded Funds (ETFs) or mutual funds. If you want to invest in individual stocks, make sure you understand the company thoroughly and then invest. The stocks represent you before you invest.
Mistakes are a part of the investing process. You will be successful as an investor if you know what they are, when, and how you are committing to them and how to avoid them. Develop a thoughtful and systematic plan and stick to it. If you want to do something huge, save some money that you are ready to lose. To ensure that your diversification exercise is successful and your portfolio bears returns in the best possible manner, avoid these six common mistakes. You will be well to building a portfolio that may provide many happy returns over a long period.