Diversification is one of the most important aspects of investing. Without it, you run the risk of losing your original investment, as well as all the value its earned.
Diversification spreads the risk of loss across your entire portfolio. This way, if an event such as a market correction occurs, there’s a chance that some of your investments will either hold or increase in value.
The Importance of Diversification Grows as You Approach Retirement
Risk reduction is crucial to building wealth and saving for retirement, but losses can still occur. If your portfolio’s value declines when you are young, you still have time to rebuild. If, however, your portfolio loses value as you approach retirement, you don’t have as much time to recoup your losses.
Key Asset Classes vs. Alternative Investments
When most of us think about investing, we typically think of key asset classes: equities, fixed income assets, and cash. Equities include stocks and shares. Bonds are fixed-income assets. Cash and its equivalents are investments that include commercial paper and U.S. Treasury bills. Many mistakenly believe diversification is simply investing in each of these three classes.
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Unfortunately, each of these investment classes tends to move in correlation with one another. This means the value of your portfolio remains at the mercy of forces that broadly move markets. A good example of this effect is the subprime mortgage crisis of 2008-09, each of the key asset classes lost value.
Alternative investment classes move in less correlation with the major markets. These types of investments hedge against inflation and other risks. The following alternative investments diversify your portfolio.
If you want to invest in foreign currency, you have several options. Buying foreign currencies in countries with strong economic growth and relative stability in their regions is becoming an increasingly popular investment. You could, for example, try investing in the Vietnamese dong, or another strong emerging market, such as Iraq, Thailand, Egypt or Turkey, and simply hold your position until it increases in value.
You could also invest in the Forex market by opening a standard trading account and taking a position on a pair of currencies with a Forex broker. If you choose this avenue, look for a broker with a proven track record that offers transparency.
If you choose to trade on the Forex market, watch out for hidden brokerage fees that can eat into your profits, such as pip spreads and slippage. Forex also offers the opportunity to leverage your initial capital outlay. While leverage is great if your trading position increases in value, you can lose many times more than your original investment if your bet doesn’t pan out.
Buying a Certificate of Deposit (CD) that earns interest based on one or more foreign currencies is another way to invest in foreign currencies. You could also buy shares of a mutual fund that invests in bonds issued by foreign governments or invest in stocks of multinational corporations with significant business operations in foreign countries.
Precious metals such as gold, silver, and platinum, are attractive investments because they tend to increase in value during times of economic uncertainty and high inflation. While they are highly liquid, meaning they can be used as currency outright or can be quickly converted into cash, they also don’t earn income or dividends, you make money on precious metals by buying when the price is low and selling when it increases in value.
The most popular way to buy precious metals is directly from a dealer, and are often sold as coins and bars. They are also used in jewelry and objects of art. Exchange traded funds (ETF) that invest in gold bullion and other metals are another popular way to invest, as is buying stocks of mining companies or buying mutual funds invested in multiple mining companies.
Precious metals can help to balance your portfolio but are directly affected by changes in the price of gold and other metals which is highly volatile. The mining of precious metals is an extremely speculative business facing increased regulation due to growing environmental concerns.
Private equity firms pool money from individual investors and institutions and then invest this capital to purchase assets such as companies and real estate. Investors receive proceeds once the firm liquidates their position, usually via direct sale or an initial public offering (IPO).
Investing in private equity normally requires a large initial deposit of funds, often upwards of $250,000, and positions are held long-term, often 10 years or more. Once the position is closed, investors usually receive returns with a rate of growth much higher than that offered by traditional public markets, making this an ideal portfolio hedge for high net worth investors.