As an investor, you would be aware of how much US inflation data affects all asset classes. Inflation is when the general price level of goods and services in an economy rises over time. As prices increase, the real value of your money diminishes. In other words, the same amount of money can buy fewer goods and services, thereby eroding the purchasing power of your money, making it essential to diversify portfolio.
In this post, we discuss why it’s important to diversify portfolios, and how you can do that!
Why do you need to diversify your portfolio?
Diversifying your portfolio involves spreading your investments across different asset classes to reduce risk. It ensures that your portfolio is not overly dependent on the performance of a single asset type, which can be risky, especially during inflationary periods.
Some assets can help you profit, while others can be considered the worst investments during inflation. Historically, cryptocurrencies, commodities like gold and oil, and inflation-linked bonds perform well during inflation. In contrast, traditional fixed-income investments, like bonds and other debt securities, experience diminished actual returns during inflationary periods.
Diversifying your portfolio serves as a risk management strategy that enhances the resilience of your investments as prices increase during inflation.
Let’s discuss in detail what factors play a role in differentiating between the worst investments during inflation from the best.
How to diversify a portfolio for inflation
Before you choose which assets a diversified portfolio would include for you, here are some factors you should consider to pick the best options:
- Assess your financial goals and risk tolerance
Before diversifying your portfolio, it’s crucial to understand your financial goals and comfort with risk. Are you saving for retirement, a major purchase, or something else? Your financial goals and risk tolerance will shape your investment strategy.
Your risk tolerance determines how much volatility you can handle in a diversified portfolio. Younger investors may tolerate more risk, seeking higher returns, while those nearing retirement opt for more conservative investments.
- Understand the impact of inflation
Inflation eats away at the real value of your money. Before diversifying your portfolio, It’s essential to comprehend how different assets react when prices increase during inflation. For example, Bitcoin has proven to be a trusted asset class that can act as a good hedge for inflation, making it a good inclusion in a diversified portfolio.
- Asset allocation
Asset allocation in a diversified portfolio involves distributing your investments among different categories like stocks, bonds, crypto, real estate and commodities, and cash. This will ensure that while one asset in your portfolio may be going through a period of volatility and losing value, the others would stay strong and make up for it.
A good example would be the Covid crisis of 2020-2021: while most asset classes and financial markets across the globe crashed, crypto went above and beyond with an astounding bull run. Bitcoin even touched its all-time high around $69,000.
Exploring cryptocurrency as an inflation hedge
In recent years, crypto has proven its worth as a potential hedge against inflation. Unlike traditional investments like stocks or bonds, cryptocurrencies are decentralized and not directly tied to any government or central bank. This unique characteristic makes them less susceptible to inflationary pressures driven by monetary policies, thus making them a good addition to a diversified portfolio.
Gold has traditionally been known as a good inflation hedge, and now Bitcoin is referred to as “digital gold”.
This is because, like gold, Bitcoin has a finite supply.
Bitcoin’s algorithm ensures that only 21 million coins will ever be created, making it immune to the inflationary tendencies of fiat currencies that can be printed in unlimited quantities.
However, it’s essential to note that cryptocurrencies also come with significant volatility, since the driving factor behind their valuation is investor sentiment. While some investors embrace them as part of their inflation-fighting strategy, others approach them cautiously due to their speculative nature.
To include cryptocurrencies in your portfolio as an inflation hedge, do remember that like any other investment, cryptocurrencies should align with your financial goals, risk tolerance, and overall portfolio strategy.
Maintaining a diversified portfolio
Once you diversify portfolio, it’s important to keep working on maintaining the diversification: it won’t be a one-off thing.
Regular rebalancing within and outside your crypto portfolio
Periodically review and rebalance your portfolio to manage your portfolio risk. Some assets may outperform or underperform during inflation, altering your portfolio risk profile. Rebalancing involves selling some of the assets that have performed well and reinvesting the proceeds into assets that may have underperformed. So you could sell some of your Ethereum and add Bitcoin to reduce your crypto risk.
Or you could sell some of your crypto and move to another asset altogether.
The goal is to bring your portfolio back in line with your target asset allocation. This helps you manage risk by preventing your portfolio from becoming too heavily skewed toward one asset class.
Risk management
Implement risk management strategies, like stop-loss orders, to limit potential losses during market volatility. A stop-loss order specifies a particular price at which an asset should be sold automatically if the market price falls to that level or below. The purpose of a stop-loss order is to limit potential losses by triggering a sale before the asset’s value declines further.
Stay informed
Stay abreast of economic indicators, central bank policies, and global events that impact inflation and investments. Informed decisions are crucial to diversify portfolio to adapt to changing market conditions.
By following these principles, you can create a well-structured and diversified portfolio that aligns with your financial goals. Periodically reassess your investment strategy to ensure it remains suitable for your goals and helps you pursue financial freedom.
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