An investing journey can feel like being on a boat in a stormy sea. You're searching for a way to invest your hard-earned cash, but this wild ride is giving you jitters along the way.

For many novice investors, the big question is: how can I protect my money from these wild waves and make it grow, too? This is where diversification comes in. It's about spreading out your money across different types of investments.

This article should help you better understand what diversification is and how to create a diversified portfolio.

What is a diversified portfolio?

Imagine you have a basket of apples you bought from different supermarkets. Within a day the apples from one supermarket go bad as they were on the shelf for a while. Unfortunately, you have to throw them out. But the disappointment is lessened because you still have a third of a basket of perfectly good apples to enjoy.

This is diversification in action. Diversification is when your portfolio is spread out across different types of investments. You could have some money in stocks, some in real estate, and maybe some in bonds. This mix is a key to keeping your money safer. It's called portfolio diversification.

A properly diversified portfolio is like having a well-balanced diet. It’s not about eating pasta all the time (as delicious as it is). You need a variety of foods for good health. It's the same with your investments - diversification can contribute to a healthy portfolio.

What is the impact of a diversified portfolio on risk and volatility?

In investing, 'risk' is the chance you might lose money and 'volatility' is how often your investments go up and down. Investing all your money in one place can be risky. If it doesn’t go well, you could lose all your money.

A diversified portfolio spreads out that risk. You're not relying on a single investment to win. So, how does it impact risk and volatility? As a general rule, it helps lower them. As your money is spread out across different investments, even if one investment is performing poorly, the others might be doing just fine.

So, in simple terms, a diversified portfolio can help to smooth out the bumps. It won't make risk and volatility disappear like a magic trick, but it can certainly soften the blows.

What are the different types of diversification?

Now, we’re going to explore the various types of diversification. Each diversification type has its own advantages and can be a key part of a strategy to build a properly diversified portfolio. They are:

1. Across asset classes. Asset classes are the big categories of assets you can invest in. This includes stocks, bonds, real estate, and more. When you diversify across these, you spread your money in different buckets.

2. Within an asset class. Now, within those big buckets, there are smaller options. For instance, within stocks, you can invest in tech companies, health companies, and many others. It's about mixing things up within one type of asset class.

3. Across investment vehicles. There are different tools or "vehicles" to invest. Think ETFs, managed funds, or other structures. Spreading your money here means you're using different tools to grow it.

4. Geographic diversification. There's also the option to go global! Investing in different countries can help to spread out the risk. If it aligns with your financial goals, it can be a good idea to not rely on the economic condition of just one country or region.

5. Sector diversification. You can also invest in different sectors like technology, health, and finance. This way, you're not tied to the fortunes of just one industry.

Remember, the goal here is to build a properly diversified portfolio. This way, you’re not just relying on one asset, country, or sector. It's about spreading out the risk and not putting all your financial eggs in one basket.

What are some examples of diversified portfolios?

Let's further unravel the knots in the concept of diversified portfolios and look at some practical examples of the different types of portfolio diversification.

Across asset classes

Sarah has saved $10,000. She's eager to grow her money.

Step 1: She splits her cash and invests $5,000 in stocks (companies' shares), $3,000 in bonds (loans to companies or government), and $2,000 in real estate investment trusts.

Step 2: Every month, Sarah reviews and adjusts her investments to maintain this balance.

Result: Sarah has built a diversified portfolio across different asset classes, potentially lowering her risk if one asset class doesn’t perform well.

Within an asset class

Next up is Liam, who loves stocks and has $10,000 to invest.

Step 1: Liam buys stocks from 10 different companies in various industries such as tech and healthcare. He initially invests $1,000 in each company's stock.

Step 2: Regularly, he checks his stocks' performance.

Result: Liam’s investments are diversified within the stock asset class. This way, even if, for example, tech stocks plunge, his healthcare or consumer goods stocks might still perform well.

Across investment vehicles

Now, meet Raj. He has $10,000, but finds investing complex.

Step 1: Raj puts $5,000 into a managed fund, where professionals make investment decisions for him, and $5,000 in an ETF that tracks a broad market index.

Step 2: Raj monitors his investments semi-annually to ensure they meet his expectations.

Result: Raj's investment is diversified across different vehicles, making his portfolio broadly diversified without the stress of choosing and managing various investments.

Geographic diversification

Here's Kristy with a neat sum of $50,000 ready for investing.

Step 1: Kristy invests in mutual funds focusing on Europe, Asia, and the Americas.

Step 2: She keeps an eye on global market conditions and reallocates funds if needed.

Result: By having investments in different geographic locations, Kristy potentially reduces the risk tied to a single region's economic downturn.

Sector diversification

Finally, meet Ava. She wants to spread her $10,000 across different sectors.

Step 1: Ava buys shares from companies in technology, healthcare, agriculture, and entertainment.

Step 2: She reviews her sector investments quarterly.

Result: Ava potentially minimises the impact of a poor performing sector on her overall portfolio by investing across various sectors.

Through these examples, we've seen how everyday people diversify their investment portfolios. These examples show that building a diversified portfolio is not rocket science. It's about making small, intentional choices regularly.

Why do long term investors often favour diversified portfolios?

The market can be quite a whirlwind. Prices of stocks and other assets can go up and down because of various market conditions. It's hard to guess what will happen next.

Diversification helps to build a sturdy shield against significant losses. Protecting your portfolio from significant losses sounds good, right? Diversification can be a suitable strategy for handling your investments, especially if you're in it for the long run.

So, besides what we've explored above, what are some advantages of a diversified portfolio that make long term investors often favour them?

1. Access to more opportunities. With a diversified portfolio, you’re dipping your toes in different investments. You're opening doors to various market opportunities this way. And you're increasing the chance of tapping into high performing investments.

2. Inflation hedge. Inflation can nibble at your cash’s value. But a diversified portfolio, with assets like real estate, potentially helps to keep that value safe and sound. It can be a shield against the sneakiness of inflation as some assets may grow faster than inflation whereas others may only move with inflation.

3. Flexibility. A diversified portfolio lets you move with ease and shift your investments as needed. You aren’t glued to one type of investment or a single market. It gives you the freedom to adapt to the market conditions.

4. Ensuring liquidity. Liquidity is a fancy word for having cash when you need it. A diversified portfolio makes sure some of your investments can be turned into cash quickly. It’s a potential financial safety net for you.

5. Long-term wealth building. Lastly, a diversified portfolio can lay a good foundation for building passive wealth in the long run. Many long-term investors want to create a steady portfolio without the constant need to monitor for fluctuations. Diversification can help to make this possible.

A diversified portfolio can be a practical and essential approach for long term investors aiming for financial security, growth, and peace of mind in their investment journey.

How can I create a diversified portfolio?

Creating your diversified portfolio can be like building a team with players from different sports - each one brings something unique to the table. Now, let's look into the key steps you might take in building your own portfolio.

What are some factors to consider?

There are several things to consider before you take action:

1. Financial goals. Define what you want to achieve with your investments. Maybe you’re saving for a home, retirement, or a dream vacation. Your goals will guide your investing decisions.

2. Risk tolerance. Assess your risk tolerance. Everyone has a different comfort level with risk. Know yours. Some don't mind the ups and downs of shares, while others prefer the stability of bonds.

3. Liquidity needs. Consider your liquidity needs. It means thinking about how soon you might need to use the money you invest. Do you have a holiday coming up that you're saving for? Are there other upcoming expenses your emergency fund might not cover? Thinking about liquidity is an essential step in making sure your investments match your life’s pace.

4. Time horizon. Your time horizon matters a lot. It’s about how long you plan to keep your money invested. Typically, investors with a longer time horizon can afford to take on more risk.

5. Investing experience. Reflect on your investing experience. It’s okay if you're a newbie or have minimal experience. Knowing your level of investing experience helps you make appropriate decisions within your comfort zone.

6. Investing style. Are you more of a hands-on or set and let it grow investor? These approaches are also known as active or passive investing. It's important to know your investing style.

Remember, the key to creating a diversified portfolio is to keep it balanced – a mix of different asset classes, considering your comfort with risk, and how soon you’ll need the money. It boils down to understanding your own investment preferences and mixing in the right factors.

Choosing your preferred diversification type and mix

After understanding your investment preferences, it's time to choose your preferred type of diversification and determine the right mix for you.

1. Learn about the different asset classes. There are stocks, bonds, real estate, and more. You've also got options like ETFs and managed funds. And let's say that from your research, you become passionate about ETFs. So, you might decide to invest in diversified ETFs (a single investment fund that spreads money across multiple asset types or sectors).

2. Decide your mix. Based on your risk tolerance (see previous section), you’ll decide how much of each asset class to include. Want to be more cautious? You can go heavier on bonds. Feeling adventurous? You may want to tilt a bit more to stocks or real estate. But if you want a broadly diversified portfolio, aim for a balanced blend.

3. Stay updated. The world of investing is always changing. Keep an eye on market conditions, such as periodically checking the spot price for assets, and adjust your strategy as needed. It's good to review on a regular basis to keep it aligned with your strategy.

4. Ask for help if unsure. There’s no shame in reaching out to an expert! You can learn by reading articles, industry research, and the investment's product disclosure statement. But if that isn't enough, you could seek advice from a licensed financial adviser who knows their stuff.

The world of investing is wide and varied. Creating a diversified portfolio is a process that involves choosing your preferred type of diversification and deciding on the right mix for you. It's about making your money work for you in the best way possible.

Rebalancing the Portfolio

Rebalancing your portfolio is like a health check for your investments. It can help keep your investments in tip-top shape while helping you stay on the path to reaching your goals. When you rebalance, you're adjusting your investments. You check all your assets to make sure you still have the right mix. This activity helps you keep a properly diversified portfolio.

Keep in mind that not all investments grow at the same rate. Some might grow at a rapid rate while others are slow. If you don’t rebalance, one type of investment can take over your portfolio. That might mess up your plans and risk profile.

Updating yourself with certain factors can help you rebalance your portfolio. Factors such as the value of your investments and their performance against benchmarks and other investments. Also, being aware of currency futures risk and commodity volatility risk is crucial. It helps you understand how certain investments can change in value. You decide how much of these assets you’re comfortable having in your portfolio. This information can help you make smart moves when rebalancing.

Now, you know how to rebalance your portfolio. It can offer a steady path to keeping your investments diversified and in line with your goals.

Remember, investing is a journey and it involves regular checks and updates. It pays to know what to track in your investment portfolio. Stay alert to market conditions, keep revisiting your asset allocation, and make sure you’re comfortable with the risks you’re taking.

The wrap up

Here's a key takeaway: diversification doesn’t mean waving goodbye to all risks. Think of it like wearing knee pads while skating. The pads won't prevent all falls, but they will offer some cushioning when you take a tumble. That’s your safety measure!

Building a diversified portfolio, whether it includes ETFs, real estate, or private investments, involves investing with a strategy. And it's fine to revisit and tweak that strategy when necessary.

Lastly, investing is a journey, not a race. Take your time. Dive into different asset classes, learn about volatility, and maybe even explore underlying ETFs. But always remember, the aim is to have a suitable diversification strategy that's right for your risk profile.

Happy investing!