6 Tips For Creating A Diversified Portfolio With Alternative Investments

Investors are constantly looking to create a diversified portfolio of investment opportunities. Understanding how to diversify a portfolio using alternative investments is an integral step to take.

There are various strategies to take when looking to diversify an investment portfolio. You can begin by looking at traditional investments such as stocks and bonds.

Investors may feel stuck on how to diversify. Here are 6 tips for developing a diversified investment portfolio.

Why Does Portfolio Diversification Matter?

No matter what economy is in play, portfolio diversification matters. In a bull market, diversified holdings lead to gains across various sectors, industries, and investment types. In bearish markets, balanced portfolios provide a cushion to spread losses and not be affected by drops in one sector.

Diversifying your portfolio lets you develop a strategy that provides steady returns and income over time.

Most portfolios rely heavily on stocks. Stocks have been the most traditional form of investing for decades. However, stocks are also among the riskiest asset class to hold in your investment mix.

Stocks are at the mercy of market conditions. If markets perform well, stock ownership brings handsome rewards. However, when markets are volatile or on the decline, your portfolio value could suffer considerably.

Rather than riding the stock roller coaster, investors have increasingly turned to mutual funds. These collections of stocks diversify your holdings at a fundamental level. However, a mutual fund is also subject to changing market conditions.

1. Recognize Common Errors in Portfolio Diversification

The uninformed investor can make serious mistakes with portfolio diversification. The most common diversification mistakes include:

Overlapping Funds

There are hundreds of mutual funds available to investors. Too many investors hold overlapping funds with the same priorities and stock types. Using similar mutual funds to diversify within a sector is a misguided approach that limits potential returns. Look at the underlying assets within your mutual funds to ensure you are not being redundant in your portfolio strategy

Over-Reliance on Bonds

Bonds are a safe way to hedge your investment portfolio. They are not susceptible to the stock market fluctuations affecting values. Instead, bonds provide a guaranteed interest rate in exchange for your investment for a period of time.

Bonds, however, should not be the only way you consider diversifying. Bond interest rates are at all-time lows right now. Investors are unlikely to see significant returns. Even when interest rates are at a high, bonds may not deliver the same returns as market averages do

2. Find the Right Asset Mix

As noted above, balance matters when it comes to portfolio mix and asset allocation. Spreading your portfolio around stocks, bonds, mutual funds, and alternative investments reduces risk and protects your long-term goals.

Different types of alternative investments have interesting features and components. Alternative investments can be an exciting way to learn about new options and balance out a traditional portfolio.

3. Understand Risk Tolerance

Each person has their own tolerance for financial risk. Age often plays a factor here. Younger investors have a higher risk tolerance, knowing they have time to make up for any losses. Those nearing or at retirement age may be more cautious with investments.

Here are some of the risk factors to consider:

Default Risk

This is the risk that a borrower, for example in a private debt investment, will not repay the interest and principal of a loan. All lending carries some risk. Looking at the recovery rate - how much an investor can expect to regain in case of a default - and the borrower’s track record can mitigate this risk.

Liquidity Risk

How easy is it for you to sell your asset if you choose to? The liquidity risk typically factors in the market climate and structure for the asset. Crypto, for example, has active markets for buyers and sellers. Real estate liquidity, however, can be shaped by how active local markets are for the type of property being sold

Concentration vs. Diversification Risk

Putting your investment “eggs” in different “baskets” is a proven, sound investment strategy. Concentrating your investments across one industry, region, or asset type can be risky.

Payment Frequency Risk

Debt payments may be paid monthly, quarterly, semi-annually, or annually. However, early repayments may reduce the overall return to the investor. Be sure to know the terms and conditions of your asset payment schedules

4. Do Your Research

Are there investment areas you want to focus on? Are there others you do not know much about? In both cases, research is key.

There are plenty of resources available to help you learn about and understand different investment types. A lack of familiarity with industries or investments can quickly derail the value of your holdings and hinder your investment goal.

While alternative investments provide a powerful opportunity for portfolio diversification, it’s important to understand the structure of each asset type. Knowing the way these investments are structured, the pay-out schedules, and fees are important considerations.

For many investors, alternative investments are uncharted territory. Some alternative investments have unique legal and tax structures, low transparency, and little regulation. These factors should be understood before investing.

5. Take Advantage of Time

Time-sensitive investments are a smart way to plan. Such a strategy involves building assets that provide dividends at different times.

Treasury bonds are one example. Buying bonds with different maturity dates called a bond ladder, helps investors leverage different interest rates over time.

6. Review Your Portfolio Often

Your investment portfolio is a dynamic, ever-changing snapshot of your financial standing. It’s important to look at the portfolio regularly to assess the performance of all its components. The reviews can identify new opportunities and allow you to shift your investment mix to maximize returns.

Understanding the options, doing the right research, and considering alternative investments provides for a rich, diversified portfolio.

Not sure on how to get started with portfolio diversification? Rocket Dollar can help you take the next step.