How Diversification Helps Portfolios Grow
Securing a balance between risk and reward is the crux of building a stable and profitable portfolio. First-time investors may be tempted to place all their capital in a single, familiar style of asset, but what happens when that asset becomes compromised by market volatility?
Diversification is a risk management strategy wherein investors build their portfolios around various distinct assets. This not only ensures that they are less impacted by any sudden market fluctuations and downturns, but also supports higher long-term returns on average. Through diversification, investors can effectively hedge their bets for a more resilient portfolio with a higher ceiling of profitability.
When passive investing, portfolio diversification can help ensure that inflation and shifting marketplace have as minor an impact on your asset value as possible without requiring a more active and aggressive investment strategy that leaves those assets exposed to significant losses.
How Can I Diversify My Portfolio?
As the term implies, diversification encompasses a wide range of methods that achieve the end goal of a robust and varied portfolio. Here are a few of the factors you might need to consider when making a portfolio more diverse:
- Asset Classes
Asset classes are a grouping or categorisation of investments that share characteristics. The commonly recognised core asset classes are stocks, bonds, cash equivalents, real estate, commodities, futures, other financial derivatives and exchange-traded funds (EFTs).
How does it diversify?
Investing in multiple asset types can reduce the risk factor of investing, establishing several cash flow streams to boost your chances at consistent returns.
- Industries and Sectors
Industries are groups of companies associated with one another based on the products and services they provide. Those industries are further grouped into broader categories called sectors. A sector can include several industries, and it is common for companies to operate within several industries at once.
How does it diversify?
Much like asset classes, industries and sectors act on each other to give investors an impression of risk and reward. Companies within a similar industry or sector will usually produce similar returns, so investing across a range of industries and sectors can generally give a portfolio more financially stable.
- Business Lifecycle Stages
All businesses can be divided into four or five stages based on the level of growth and progression they’ve achieved. Though there are a few schools of thought on what those stages are, they generally follow a basic structure of:
- Startup – High Growth, High Risk
- Growth – High Growth, Low Risk
- Maturity – Low Growth, Low Risk
- Decline – Low Growth, High Risk
A publicly-traded company’s lifecycle stage is determined through financial analysis, which leads to its stock being categorised as either a growth or a value stock from an investor’s perspective.
Growth stocks are typically associated with the first two stages of a company’s lifecycle and have a high potential for expansion based on internal and external influences like a superior product offering, a lack of market competition or successful fundraising.
Value stocks are mostly tied to established businesses in the maturity stage of their lifecycle. These stocks are undervalued due to factors like speculation or recent news but are not yet in decline. Value stocks are expected to return to their target price once the period of undervaluation ends, but some even achieve further growth over time.
How does it diversify?
Business lifecycle stages can determine and mitigate the risk associated with publicly-traded companies. Building your stock portfolio around a combination of growth and value stocks can be an easy answer to diversification.
- Market Capitalisation
Market capitalisation (or ‘market cap’) is the total value of a company’s outstanding stock shares. It is used by investors to determine the worth of a company’s stock and its size. Companies are categorised into the following market caps:
- Large-cap – Companies with a market value of $10bn or more
- Mid-cap – Companies with a market value between $2bn and $10bn
- Small-cap – Companies with a market value between $300mn and £2bn
Market cap not only determines what investors should pay for a company’s stock but also its growth potential. A long-established company with a high market cap, for instance, would be considered a reliable, if conservative, investment. A company with a low market cap that’s been around for a similar amount of time would be considered stagnant in terms of growth and a bad investment.
How does it diversify?
Similarly to lifecycle stages, the market cap can help define the risk and reward of investing in a company while providing a guideline for ensuring your investments are diverse and distinct. Companies of differing market caps will also differ in returns and be susceptible to or protected against different risks.
- Foreign and Domestic Investments
One particularly effective method for diversifying a portfolio is by investing in a combination of physical and domestic assets. By developing international cash flows in an increasingly globalised marketplace, investors can spur economic growth in undervalued, developing markets while safeguarding against national economic downturns.
How does it diversify?
Mixing foreign and domestic investments into your portfolio is a geographical solution for risk management through diversification. Even when markets fluctuate globally, it’s unlikely that every country will be impacted on a similar level, allowing international portfolios to be much more resilient overall.
- Tangible and Intangible Assets
Many portfolios blend tangible and intangible assets to stay diverse. Tangible assets like property are usually less liquid and have a finite monetary value, while intangible assets have a projected theoretical value but allow for more liquidity and flexibility. Some of the major obstacles to investing in tangible assets are physical location, the need for appraisal and the possibility of their degrading over time. In recent years, management companies and digital media have been able to streamline the process of investing in tangible assets.
How does it diversify?
Tangible assets have a low correlation to non-tangible asset classes, which means they aren’t often impacted by the same market forces. Housing markets, for example, can be very stable compared to stock markets, with assets rarely decreasing in value. This makes them ideal for balancing out portfolios which may otherwise rely on several intangible assets like stocks and bonds.
Remember: the key to portfolio diversification is nullifying the poor performance of certain assets with the positive performance of others. As a risk management strategy, portfolio diversification is most impactful when securities are not entirely correlated, allowing them to respond in opposing ways to the same market influences.
Affordable Housing for Portfolio Diversification with Concept Capital Group
As a tangible asset in a growing industry with a relatively low-risk profile, affordable housing is well-suited to retirement planners seeking to turn a nest egg into a reliable source of passive income. With the demand for affordable housing rising and local governments increasingly relying on the private sector to provide solutions, the market has a growing potential for portfolio diversification.
At Concept Capital Group, we offer investors the unique opportunity to diversify their portfolios through the growing affordable housing market. Supported by government-funded social housing programs, our buy-to-let properties benefit from guaranteed tenancy agreements and low initial costs to provide consistent monthly returns throughout a 12-year contractual period.
To find out more about our affordable housing solutions, contact our sales team today for a free consultation.
