We’ve all heard the old proverb, “Don’t put all your eggs in one basket.” Whether it’s referring to applying for several jobs instead of just one, or not throwing your entire life savings behind one venture, this phrase cautions about the risk of concentrating all your resources in one area. In investing, this piece of wisdom is known as the principle of diversification.
What is Diversification?
Diversification is an investing strategy designed to help lower risk. Rather than directing funds towards one single investment or type of investment, it is generally considered better for investors to diversify their investments into many different companies, industries, and asset classes that are not exposed to the same risk. The idea is that a portfolio constructed of different kinds of investments will, on average, yield higher long-term returns and lower the risk associated with any individual investment.
Diversification isn’t meant to maximize returns, however. Spreading your money out over lots of investments necessarily means you won’t earn as much if one of those investments performs well. But on the flip side, if one of those investments performs poorly, it won’t affect a diversified portfolio as much. This stabilizing effect is the key reason why many investors -- especially those who are just getting started -- choose to diversify.
By Asset Class
A simple way to diversify your portfolio is to make sure it includes investments from different categories, or asset classes. Asset classes are broadly divided into traditional investments (usually stocks, bonds, and cash) and alternative investments (such as real estate, cryptocurrencies, and commodities). Different asset classes vary in how they respond to economic ebbs and flows, which is why it can be advantageous to have a variety of investments from different asset classes within your portfolio.
While investments such as stocks and bonds are widely available to the everyday investor, some alternative investments such as real estate have historically only been available to accredited investors. However, with the advent of technology-based platforms like Groundfloor which open up access to real estate investment opportunities to everyone, regular investors can more easily diversify their portfolios across more investment categories, which can help build and safeguard wealth.
Within Asset Classes
In addition to diversifying across asset classes, it is important to consider diversifying within asset classes as well. For example, if your portfolio is heavily concentrated in stocks from companies like Apple, Google, and Facebook, you may want to consider expanding your holdings into non-technology companies. Since companies in the same industry tend to have similar characteristics and will respond similarly to economic changes and cycles, it can be wise to balance them out with holdings in other sectors. Stocks can also be diversified in terms of company size (also known as market capitalization) and location (whether foreign or domestic).
This is also applicable to other asset classes. Bonds, for example, can be differentiated by type of issuer (the government, a municipality, or corporation), term length, and credit risk level. Similarly, diversification in real estate can be achieved by investing in a variety of property types (i.e., commercial vs. residential), properties in a variety of sizes and locations, and properties that have a variety of risk profiles.
While diversification is beneficial for most investors, it can be difficult to achieve. Choosing where to invest your money requires time and research, and investing across and within different asset classes can be expensive, especially for the individual investor. However, there are ways to facilitate the process. Individual investors often choose to invest in pre-bundled groups of securities in the form of mutual funds, index funds, and exchange-traded funds (ETFs), which allows them to achieve instant diversification without the headache of researching each individual offering.
Additionally, alternative investing platforms with low minimum investments have arisen to help ease the financial burden of diversification. Groundfloor's real estate investment platform, for example, has a minimum investment size of just $10 per project, which enables meaningful diversification for everyone, on any budget. With an investing budget of $1,000, for example, investors can diversify into as many as 100 different projects of their choosing. If sorting through each individual loan isn't for you, Groundfloor's Investment Wizard tool can help you quickly locate available loans that fit your personal investing criteria, so diversification becomes a cinch.
Diversification is a powerful tool to help mitigate risk and achieve steady returns within your portfolio. As the financial and investing world becomes increasingly accessible to everyday investors through the power of technology, it is easier than ever to take advantage of the variety of diversification strategies available to help you build and preserve wealth.
Ready to add real estate to your investment portfolio? Groundfloor provides a marketplace of residential real estate projects to choose among to build your own custom portfolio of private real estate investments, starting with just $10 per project. Join today to take advantage of the power of real estate in your investment portfolio.