Embarking on the journey of investment requires a nuanced understanding of diversification, a strategic approach vital for navigating the complex terrain of financial markets. More than a risk mitigation technique, diversification works as a dynamic management strategy. It becomes an armor against the unpredictabilities of financial disruptions, promising risk absorption and a pathway to higher returns.
What Is Diversification and Why Is It Important?
For many fund managers, financial planners, and individual investors, diversification is a management strategy that helps manage your investment portfolio risks by investing in various asset classes and different investments within these classes. They absorb the risk and shock of any financial disruptions and yield a higher return.
Diversification mitigates losses during periods of economic and stock market uncertainty because different types of investment and asset classes behave differently at different times and are impacted differently by market conditions.
You can meet various investment goals, such as income generation and capital preservation. It also helps increase your purchasing power over time to help you combat future inflation. However, a diversified portfolio can be challenging to manage and monitor effectively. It does not eliminate risk, it simply reduces it. It can be an expensive endeavor due to fees incurred when buying particular investment types.
Investment Options
Consider a combination of the following investment options to diversify your portfolio.
1. Bonds
A bond is a loan to a government entity, corporation, or other organization made by investors in exchange for interest payments from the borrower. They represent a debt. Most bonds are fixed-income investments; you will receive a fixed earning amount at a fixed interval till the loan term ends. Some terms that are helpful to know before investing in bonds include:
- Face value: The bond's actual worth on its maturity date. This is also called "par value."
- Maturity: The date on which borrowers repay the principal amount.
- Coupon: The annual interest rate, which equals the bond's face value
- Callable bond: The issuer can repay the bondholder back before the term ends.
- Zero coupon bond: There are no periodic interest payments – the cash returns come at maturity.
- Floating-rate bonds: Interest payment changes according to the price of a commodity or other short-term benchmark rates.
- Put bond: The investor can demand early loan repayment, which cancels the loan.
Bonds are less volatile and more stable than stocks but are sensitive to interest rate changes.
2. Stocks
When you invest in stocks, you buy ownership shares in a public company. They have the potential for capital appreciation over the years. The two equity investments below offer different benefits:
- Preferred shares: Preferred shares have a fixed (typically higher) dividend amount paid before dividends are paid to common shareholders.
- Common shares: If the company grows and performs well, the stock price will increase. If you decide to sell it to another investor, you could earn a profit. It also generates passive income by paying dividends. Common shares grant voting privilege, giving you a say in how and who runs the company.
Stocks have a low barrier to entry. You can invest as much or as little capital as you are comfortable with. They are highly liquid and can be sold and bought quickly on the market. They act as a hedge against inflation. However, stocks are unpredictable, and economic events, global crises, and company performance can fluctuate prices. Factors like the type of account holding stock and holding period can subject stock scales to capital gain taxes.
3. Cryptocurrency
Cryptocurrency uses decentralized networks and blockchain technology. Blockchain technology is a set of information blocks connected to an online ledger. The block contains an independently verified set of transactions. It is secured by cryptography, enabling online payments without third-party intermediaries. This makes it challenging to double-spend or counterfeit.
Cryptocurrency removes single points of failure as it does not require centralized intermediaries like monetary institutions or banks to police transactions and enforce trust between two parties. Instead, the use of private and public keys and incentive systems, such as proof of stake and proof of work, secure transfers. This makes the transfer faster than standard money transfers. It can also streamline remittances and be used to generate returns and profit.
However, as transactions are pseudonymous, they allow for criminal use and leave a digital trail that agencies like the FBI can follow. Mining popular cryptocurrencies also requires significant energy expenses. Bitcoin is one of the most popular cryptocurrencies in the world. You can mine Bitcoin through software or buy Bitcoin online using a cryptocurrency exchange in fiat exchanges (US dollar).
4. Precious Metals
As rare commodities, precious metals have high economic value. They carry no credit risk, cannot be inflated or printed more, and have intrinsic value, which grants them unique inflationary protection. They are a fairly liquid investment and act as a hedge against inflation. Most financial advisors recommend you dedicate 5% to 10% of your portfolio to precious metals. Examples of precious metals include:
- Gold: Timeless and incredibly durable as a store of wealth, gold makes for a safe investment during political instability.
- Platinum: Due to its rarity, it can fetch higher prices than gold. However, you may face insurance, storage, brokerage, and management costs.
- Silver: Its price fluctuates more due to its role as a store of value and industrial metal.
- Palladium: It is rarer than gold and can not be substituted. It is often used for manufacturing electronic and industrial products.
5. Real Estate
Buying and owning real estate is a satisfying and lucrative investment strategy. You purchase property or land intending to resell it at a higher value later to gain substantial returns. You can also rent the property to receive monthly income, but you will be responsible for insurance, maintenance, and repair costs.
For a high return on your investment, ensure the property location is ideal, such as near basic amenities like schools, grocery stores, parks, hospitals, and transport hubs. Check the property valuation and analyze trends to ensure its value will rise, such as by looking at new infrastructure being built in the area.
Endnote
Diversifying your investment portfolio is a strategic move that guards against risks and enhances potential returns. Each avenue has its fair share of benefits and considerations, from traditional choices like bonds and stocks to contemporary assets like cryptocurrency and precious metals. While diversification is a robust risk management tool, be aware of the challenges and costs associated with maintaining a diversified portfolio.
