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5 essential lessons about portfolio diversification

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Essential tips about portfolio diversification

Diversification, diversification, diversification. It's crucial if you're looking to reduce risk and improve your overall portfolio returns. But even though many of us know this mantra by heart, we fail to apply it successfully in real life. To better understand and apply the concept of diversification to your portfolio, here are a few simple dos and don'ts you should follow:

1. "I own a variety of stocks, so that must mean I'm well-diversified."

Wrong. You don't just want a variety of stocks — you probably also need other investment products, such as bonds, cash or cash equivalents, ETFs, or options.

This is because each asset class has varying characteristics and benefits, such as differing risk/reward profiles, costs, and time horizons that can help manage your overall risk. (If you're new to investing, the Securities and Exchange Commission offers an excellent primer on diversifying your portfolio effectively.)

But don't stop there — you should aim for diversity within each asset class, too, for example, by holding stocks across various industries and sectors. Different sectors and industries perform at different paces most of the time, so holding assets across a variety of sectors ensures that your portfolio contains some counterweights. Some investments, such as precious metals, outperform when inflation expectations are high. Bonds are a favorite when too much risk is perceived in equities. Defensive equity sectors can also be a safe haven. Think about ways to diversify by adding counterweights to prevailing or existing trends.

2. "The economy is so globalized, that having international exposure isn't necessary anymore."

Wrong. Though globalization and increasing levels of global wealth have reduced the variation between international and domestic asset performance to some degree, having international exposure is still key. Emerging market stocks can still generate greater gains in some cases, and the timing of recessions and recoveries still varies across nations. International diversification is still a key way of reducing risk, whether through funds, equities, bonds, or currencies.

3. "Even though I've already created a diversified portfolio, I need to think about diversifying regularly."

Right. Rebalance your portfolio regularly to maintain ideal diversification. Let's say you own a fancy tech stock that has a record-breaking year. The stock shoots up in value, while other stocks you own in less glamorous sectors don't do as well. At the end of the year, you might find you have more money in tech than you originally wanted. In order to remain fully diversified, rebalance your portfolio to reflect your original target mix. That can man selling some assets to purchase more of others that help meet your diversification targets.

Stay up-to-date with where your money is now, as well as your current investment mix. Don't forget that times change, as do your priorities, and the investment products on the market. Stay abreast of new developments, and make sure your choices reflect your new knowledge and what your goals are today.

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4. "I can diversify my portfolio by myself."

Maybe. Do rely on technology to help track your portfolio and diversify. Most 401(k) plan management tools, robo-advisors, and online trading platforms allow you to see your overall portfolio categorized by asset classes and/or sectors. Use these tools to see how your money really stacks up, and whether your diversification mix is ideal. Maybe you can structure an adequately diversified portfolio, staying flexible to a changing investment environment, and properly managing your asset allocation. But that can be both time-consuming and challenging, so you should have no hesitation whatsoever regarding the use of technology to help you achieve an ideal investment mix.

5. "I own a target-date fund. Isn't that enough?"

Maybe. But don't assume a target-date mutual fund or ETF is enough diversification insurance. Sure, these may seek to internally diversify based on your expected date of retirement, but your particular needs and objectives may differ from others in your age group. Also, consider whether the target date you choose is appropriate for you. In some cases, it may be helpful to own two or three target-date investments, for example, with retirement dates of 2045 and 2050, instead of just 2045. This can help better fine-tune your diversification, risk/reward, and time horizon goals.

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Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.