How to diversify an investment portfolio

Blog March 2024

Investing basics

Betting all your money on one horse is nothing more than a gamble. You either earn everything or nothing. Though it’s not the same (everything or nothing) with investments, the exposure to risk can be largely reduced if you learn how to diversify an investment portfolio.

What is diversification?

Diversification of an investment portfolio is a strategy that utilizes different asset classes, investment vehicles to minimize risk and maximize returns.

Though diversification might yield a higher return in the long run, it is a risk management strategy that minimizes the risk against market conditions and industry/sector fluctuations.

Having the eggs laid in more than one pot will help reduce the exposure to risk within the asset class and across asset classes. Also leveraging the opportunity to reap the best returns from various investment classes in the long run.

Understanding diversification

Consider yourself owning equity of company A for $1000 and the quarterly sales dipping all time low. The stocks are beaten down to 50%. So your investment value becomes $500 – 50% loss. Investing $500 in company A and $500 in Company B in the same scenario will lead to a loss of $250 with $750 in hand – 25% loss.

Now, the same scenario except you have invested your $1000 in Company A – $200, Company B – $300, Company C -$100, and Company D – $400. Now the 50% fall in company A stock price will only eat a $100 of investment value which is just 10%. This 10% in loss to is compensated by profits from other investments if analyzed and invested wisely.

Diversification helps elude unexpected losses by reducing risk exposure to one asset or asset class. The investments within a portfolio need to balance out the other in case of unforeseen risks for the diversification to be effective.

To achieve the best outcome through diversification, you need to assess the risk and returns of the investments and plan in an opposing way within and across asset classes.  So here are some common ways to diversify your portfolio.

Diversification across asset classes

Diversification across asset classes is the most common and basic investment strategy for the best risk to reward outcomes achievable with the least financial knowledge. Of the five main asset classes – Cash, fixed interest, equity, property, and commodity investing in at least 3 should reduce risk exposure to a good extent.

From a border perspective, asset class diversification doesn’t guarantee much higher returns, it strengthens against the undulations of the market. However bad the equity and real estate performs due to market risk (systematic risk) asset classes like fixed interests are guaranteed to return a minimal interest rate.

Diversification within an asset class – Equity

The concept of diversification within an asset class works best in equity. They work best to reduce exposure to unsystematic risk – risk caused due to a company’s poor performance or the sector/industry’s downfall.

Simply by investing in different companies from various sectors unsystematic risk is kept in check.

There is another way to diversify investments within an asset class – based on market capitalization. High market-cap companies are generally low risk and low yield.

On the contrary, low market-cap businesses are high-risk but yield higher returns. Choosing a mix of low-cap and high-cap companies based on your risk appetite helps reduce risk.

Diversification within asset classes also applies to other asset classes like splitting across different commodities and investment vehicles.

Diversification across markets

Systematic risk risks are mostly tied to the market (country) hence institutional investors often invest a part of their portfolio in foreign markets in the form of shares, REITs, or debt investments. Foreign investments are a great opportunity for high returns with the choice of markets let to you.

Diversification based on appetite for risk

This is the crucial part of diversification that everyone must consider. But it is hard to implement unless you have a financial background.

Putting together a portfolio based on risk appetite makes sure you make enough returns for your short-term goals and take a planned risk with the best probability of high returns. The percentage of high-risk vs low-risk investment can be planned only based on the investor’s short-term and long-term goals.

How to diversify an investment portfolio?

1. Define your Investment Goals

Investing for a purpose yields a better-structured investment portfolio than simply investing in the easily available avenues. So start with accessing your needs – both short and long term.

Even if you are not sure about the exact expense in a particular time period, something like a children’s higher education fee in the 10th year will give you a rough idea. Make a timeline of goals along with the returns you are expecting.

2. Decide your investment capacity and appetite for risk

Now access your investment capacity and do a rough projection of your investment with an average rate of return. Factor in inflation and career growth to get a clear picture.

If your current investment capacity exceeds your goal, you have a good risk appetite, if not, look for ways to increase your investment cut-off every month.

3. Identify, classify and pick the investment opportunities

List the investment options that are available to you along with the duration, risk, yield, and minimum threshold of investment. You might need experts’ help here.

4. Create your diversified investment portfolio

Find your palette of low, medium, and high-risk investments and aggregate what works out best to meet your goals to leverage the best of the market conditions. Now start filling in your investment options as per the risk quota in the ascending order of returns. Do not remember to diversify within asset classes.

Benefits of a diversified investment portfolio

  • Reduced risk exposure.
  • Higher returns in the long run.
  • Planned risk-taking capability on high-risk high-return investments.
  • Higher chances of meeting financial goals.

Drawbacks of diversifying investments

  • Comparatively reduced returns in the short term.
  • Might lead to higher transaction costs when a smaller investment is split into many avenues.

The drawbacks are minor when most of your financial goals are long-term. But what about the days of effort you need to put in to understand and analyze investment options. If you feel that is a lot, look at investment funds like mutual funds and private equity Real Estate investment vehicles.

They diversify from within and actively manage to bring down the risk to the lowest possible level and make good profits, usually higher than the market.

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Any questions

What is affordable housing?

Affordable housing refers to housing units designed to be accessible to low- and moderate-income families, typically costing no more than 30% of their gross income.

The definition of “affordable” typically varies depending on location and income levels but generally encompasses rent or purchase prices that don’t exceed a certain percentage of a household’s income.

What is Section 8 housing in the US?

Section 8 is a federal rental assistance program in the US run by the Department of Housing and Urban Development (HUD) that helps low-income families and individuals afford decent and safe housing in the private market. 

The program provides eligible households housing choice vouchers that cover a portion of the rent directly to the landlord, with the tenant paying the remaining amount. Property owners who participate in Section 8 agree to rent units to qualified individuals and families at a rate approved by the program.

How can I invest in Section 8 housing?

There are several ways to invest in Section 8 housing:

  1. Direct ownership: You can purchase a property approved for Section 8 and rent it to a qualified tenant using a voucher and receive rent subsidized by the government.
  2. Real estate investment trusts (REITs): REITs pool investor funds to purchase and manage income-producing real estate, including affordable housing.
  3. Limited partnerships: Limited Liability Companies (LLCs) offer another option for investors to pool resources and invest in affordable housing projects.
What is the difference between multi-family and single-family properties?

Single-family property: This refers to a standalone house or unit designed for and rented to one household.

Multi-family property: This refers to a property containing multiple dwelling units, such as a duplex, apartment building, or condominium complex. Multi-family properties offer the potential for higher rental income but typically require different management strategies and considerations compared to single-family homes.

What is the difference between buying and flipping houses?

Buying and holding: This involves purchasing a property to keep it as a long-term investment, generating rental income and potentially appreciating in value over time.

Flipping: This involves buying a property, renovating it to increase its value, and then selling it quickly for a profit. This is a more hands-on strategy with higher risks and rewards compared to buying and holding.

How much do I need to start investing in affordable housing real estate?

The minimum investment required varies depending on the chosen method. Direct ownership typically requires a higher initial investment for the property purchase, and renovation up to Section 8 standards, while other options like REITs might have lower minimum investment amounts.

Do I need to be a US citizen to invest and own the property?

No, US citizenship is not a mandatory requirement for investing in affordable housing in the US. However, specific restrictions or regulations might apply depending on the investment method and your residency status.

It’s crucial to consult with a professional to understand the legal and tax implications for non-citizens.

Do I need to pay US tax as an overseas investor?

This depends on the type of investment, your residency status, and any applicable tax treaties between your home country and the US.

Consulting with a tax professional specializing in international investments is highly recommended.