Smart investors know that diversifying their investments reduces risk. You want to diversify your portfolio in terms of asset classes, investment vehicles, industries, risk profile, and other classifications. Diversification maximizes financial returns by investing in different categories of securities that each react differently to the same event.
It doesn't bulletproof your portfolio, but diversification is a critical way to reach long-range financial goals while minimizing risk.
Investing in equities, whether directly in an individual stock or through mutual funds, or exchange-traded funds (ETFs) that track equity indexes, may deliver a greater return on your investment than savings bonds. Still, equities also have a higher risk of not providing a good or consistent return.
When significant events happen—such as the coronavirus or political unrest—the stock market gyrates. If your portfolio has only public stocks, you could experience a big drop in value. If you counterbalance your investment in stocks with investments in bonds, only part of your portfolio would be affected as typically, the stock and bond markets move in opposite directions. Suppose your portfolio is diversified across both asset classes. In that case, a downturn in one will be offset by an upturn in the other. In general, many bonds are considered to be lower risk than stocks, though neither asset is risk-free.
Investments in stocks and bonds may also come with fund management fees, transaction fees, or brokerage charges. Costs for buying, selling and even for holding them can add up and need to be accounted for when considering your overall return on investment.
Given market volatility, it's important to consider more than just publicly listed stocks and bonds when diversifying your portfolio. By and large, it is easier to invest in public companies than private ones. Public company stocks are traded on the stock exchanges and are easily accessible through brokerage accounts with a variety of providers. Until recently, equity investments in a private company used to be only open to the wealthy. It also required a minimum investment of tens of thousands of dollars and the opportunities were harder to find. Investing in private debt, that is, giving loans to private companies, used to be the same – wealthy individuals loaned large amounts to private companies, which were most likely mid-sized companies.
The investing landscape changed however when the JOBS Act was created after the 2007-2008 financial crisis.
It allows any American, 18 years or older, to invest in private companies. In a nutshell, private debt generates financial returns from interest earned on the loans. Private equity makes money as the value of the company increases, so the value of the stake or shares one holds in the company also rises. In private equity, you make your money when the company goes public or is bought by another as this gives you an “exit” – meaning a way to sell your shares in the company. Private debt companies typically employ teams with strong commercial banking backgrounds and expertise in the debt instrument they are offering. These teams assess the ability of companies to repay the debt. Though the reward may be more significant, private equity is usually a riskier investment than private debt as the investment is not secured like a loan may be.
The use of private debt was growing among mid-sized companies before the Great Recession, but now fintechs—financial technology companies—are making these types of loans more readily available to small businesses. These loans are usually more flexible and responsive to the challenges small businesses face than traditional banks are. The small business gets needed financing and small investors get a good return.
Investing in private debt among institutions and the wealthy was also growing before the financial crisis. Now you can invest too. Companies like Worthy make it easy to invest in growing community businesses by assessing the risk for you and by bundling investments to spread the risk. Instead of needing to invest tens of thousands of dollars, many of these new fintechs also offer micro-investing with as little as $10.
By diversifying into private debt or equity, you're not only helping to move the economy forward, but you’re protecting yourself from the ups and downs of the market.
