Let’s look at the types of investments you might consider and how to build your portfolio for the long term.
Does low risk always mean lower returns? And, to increase returns, do you have to take more risk?
There actually is a way you can achieve higher returns without taking on more risk: by diversifying your investments!
The meaning of Diversify is to spread out your money over different types of investments.
Diversification allows an investor to lower risk without lowering the expected return. By combining different types of investments in a smart way, you spread out your investment over a wide variety of sectors and asset classes. The risk that any specific investment will fail is partially canceled by all other investments and overall risk is lowered.
Diversification differs from asset allocation in that when you diversify, you choose different sectors or types of investments within a particular asset class (say, for example, equities), as opposed to asset allocation which is spreading your investment over asset types with different risk (e.g., equities, bonds, and cash).
Having a diversified portfolio invested in a variety of stocks and a variety of sectors lowers the risk of losing much money when one particular investment declines. Too bad diversification cannot protect against risk that the entire market and economy may have a bad year (or more).
Building a Diversified Portfolio
The most basic method of diversification is to buy a mutual fund or index fund instead of the stock of just one company. Mutual funds could own shares in twenty, thirty, forty, or hundreds of companies giving you instant diversification. But, how can we diversify in an even better way to increase returns without increasing risk? Below is just one example of a properly diversified portfolio that you may consider. Before we start, though, let’s learn one more definition: “standard deviation.” It’s sort of confusing, but let’s just say that standard deviation is a measurement of risk that shows how much the returns of an investment stray from the average. The lower the number, the more consistent the returns and less risk; the higher the number the more variance and more risk.
