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Three Types of Portfolio Diversification You Need To Know

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Three Basic Strategies to Diversify your Portfolio

Investing is all about meeting your return goals without taking unnecessary risks.  The number one strategy for managing risks is through diversification.  There are three types of diversification that you can apply to your portfolio

  1. Asset Classes
  2. Industries or Sectors
  3. Issues and counter-parties

Asset Class Diversification

There are five types of asset classes that you can utilize to diversify your portfolio.

  1. Cash and cash equivalents – this type of asset class will earn you the least amount of money. It’s the money you use for your rainy day fund. Most financial advisors will talk about having a 3-6 months of living expenses saved up and sitting in one place.  This should be your savings account that is backed by the FDIC.  This money should be available at a moment’s notice in case you run into a disaster.  Some people forget the bank and keep this money “under their mattress” or somewhere in their home.
  2. Owning part of a business – this type of asset is buying into part a company. You can do that a number of ways. Investing in stocks via the stock market is the number one and simplest way to own part of the business.  The main strategy in the market is simple buy low and sale high.  If you want even more diversification you can buy a mutual fund which would have a basket of stocks from all different industries in the fund.  If you are very well off you can buy into a franchise like a McDonald’s or a pizza shop as a limited partner for fractional ownership.  I have found a number of businesses looking for investment partners are Craigslist.
  3. Fixed income securities – this is where you are loaning money to people, businesses, or even buying an annuity. When you loan money to a business this comes in the form of a bond. You are giving the company part of your money in exchange for a series of payments usually once every six months in the form of a coupon.  You can purchase corporate bonds, municipal bonds (money earned from these is tax free), sovereign bonds, and even underwritten mortgages.  If you want a more human component and want to loan money to people use websites like Lendingclub.com and propser.com where you can select your risk tolerance and then the websites will take your investment and provide you with a basket of loans made to individuals who are borrowing money from the site.
  4. Real estate – this is where you are investing in real estate assets. This could be deciding to buy a home instead of renting. You can even purchase a multi-family property and live in one of the apartments while earning money from the rest of the apartments.  The easiest way to buy real estate would be to buy a real estate investment trust in the stock market.  These stocks usually offer huge dividends.  Websites like fundrise.com also allow you to invest in real estate projects via crowdfunding.  You need to diversify here too.  For example, if you own a residential property that is generating you income you may to consider buying an office or retail property as your next investment.
  5. Commodities – this can be anything from copper to wheat. The main commodities are gold and silver. The goal here is to have something that is valuable all by itself.  Investing in gold and silver coins is a great idea.  You need these assets because of situations like the one happening in Russia.  Economic sanctions against that country have made the Russian Ruble almost as valuable as toilet paper because of inflation.

Sector or Industry Diversification

A great diversification strategy is to reduce correlated risks.  The best way I can explain this is with an example.  Let’s say you have some gold coins that you purchased, you own stock in mining companies that specialize in gold, and you have purchased the gold ETF.  Your entire portfolio is now based on how well gold does.  If gold should decrease in value the entire value of portfolio will decline.  This is why you need to own all different types of stocks and bonds.  You should own a lot of different companies if you are managing your own stocks that operate in different industries.  A lot of mutual funds will handle this for you if you don’t want to be a hands on investor.

Exposure to Issuers and Counter-Parties

The importance of this type of diversification was shown during the recession and financial collapse from 2008-2009.  For simple example let’s look at the insurance industry and hurricane Katrina.  You have insurance agents who sold flood insurance to homeowners and there were a handful of insurance companies that guaranteed payments for these policies if there should be a flood.  Lloyd’s of London was insuring hundreds if not thousands of residential properties in the New Orleans area.  Then when Katrina hit the company almost went bankrupt paying out all these claims as the issuer on all the policies.

For a working example this means you don’t want securities tied to the same entity.  Buying Coca-Cola stocks and bonds is not a great idea.  You should purchase one or the other.

Additional Strategies For Basic Diversification

As you grow richer you might also want to start thinking about your geographic exposure.  Having a portfolio built of all American companies might not be a good idea because if America were to go back into a recession your entire portfolio would decline.  In relation to geographic exposure you may also want to consider currency exposure.  If you invested in companies that operate in Europe for example the profits of those companies would depend on the strength of the Euro.

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About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.

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