Let’s be clear: investing is not a roadmap to instant wealth. Investing is a plan for the future.

Your retirement years may be far ahead, but it is vital to start investing early as you will reap more benefits the sooner you start. Investing’s key ingredient is time. The same investment made at age twenty and at age thirty would yield significantly different returns. The investment made at age twenty can produce double the returns of the investment made at age thirty. The longer money is put to work, the more wealth you generate in the future. And you’ll want to generate enough wealth to replace the steady paychecks you collected when employed.

It’s not enough to invest early, however. You have to invest smart. You do this by building a diversified portfolio.

There are two basic rules in investing: (1) Risk can never be fully eliminated, and (2) The higher the potential returns, the higher the risk – and vice versa. These principles create a difficult quandary for most investors: high-risk investments may have higher returns, but who among us wants to gamble with his hard-earned cash?

To mitigate risk, diversify your investments. Diversification simply means allocating your funds among many different asset classes – spreading your eggs in different baskets, in other words. The more diversified your investments, the more protected you are. Even if an investment fails, your returns will stay positive.

Here’s an easy illustration: you decide to buy stocks. Perhaps you have chosen to invest in transportation because it seems safe. After all, people always need transportation. But what happens when oil prices hike dramatically? Airline and taxi companies will struggle to make a profit and stock prices will drop. Worse, what if the company goes under? You will lose all of your investment. But if you spread your money across stocks of three, five, ten, or more companies, the impact of one company going under will be less painful on your overall investment.

Yet diversifying across many company stocks isn’t enough. What happens when the stock market is in trouble? Good diversification is more than buying into many of the same asset class, but spreading risk across different asset classes. In other words: don’t just invest in stocks, invest in bonds, time deposits, and gold too.

Keep in mind, however, that everyone’s investment portfolio will look different. This is because every investor balances risk and reward according to his or her risk tolerance and future goals.

Risk and age are the two primary factors that determine the contents of an investment portfolio. People with a high risk tolerance will aim for investments with the highest returns, no matter how risky. The older people become, however, the more their risk tolerance will shrink – and thus they are generally more likely to lean towards safer, income-generating products to ensure passive income during retirement.

An aggressive investor can spend 90% of their investments on high-risk instruments like stocks. However, to diversify and to hedge against volatility, he should supplement the other 10% of his portfolio with bonds and other low-risk investments.

Most people are risk-averse. For a risky investment to be worth it, they will demand a higher return. Otherwise, they will stick with safer instruments – even if the interest rates aren’t high. Based on a low risk tolerance, an investor could spend 70% of his investments on safer products like bonds and time deposits, 20% in stocks, and 10% in cash and equivalents.

(Note: the percentages above are arbitrary and are meant to show examples of diversified portfolios based on risk tolerance)

The main idea here is to balance risk and reward according to your personal tastes. You should look at all asset classes and see how they will fit into your portfolio. For example, go ahead and buy stocks of varying companies or buy different precious metals – not just gold, but also silver and platinum. However, it is just as or even more important to diversify into different asset classes to hedge against risk. That way, the risk within each asset class is spread out.

When stock markets are bleak, stock prices will tumble but gold prices will generally rise. If you have a well-balanced portfolio, your loss in stock value would be hedged and minimized due to the rise in gold prices. Your overall portfolio may still be making a positive return depending on your asset allocation.

An income-based product is an investment that provides returns or passive income in the form of fixed periodic payments. Whether an investor is paid back monthly, quarterly, half-yearly, or annually, an investor is paid back in fixed periods. He will also earn back his principal at the investment’s maturity. Investing in instruments that provide passive income is prudent as they can replace your paychecks when you retire.

For instance, you can invest in dividend stocks rather than growth stocks if you wanted an income-based product. Dividend stocks pay stockholders part of a company’s earnings in fixed periods – thus, replacing an investor’s income.

Other examples of income-based products are time deposits, bonds, and peer-to-peer financing. All these instruments replaces your principal in fixed periods. Time deposits and bonds are relatively less risky, but their interest rates aren’t high. Investing in peer-to-peer financing requires little entry cost, but as in any investment, carries risk as the businesses you fund may default.

At the same time, peer-to-peer financing also offers higher returns up to double-digit rates annually. The risk of investing in peer-to-peer financing can also be mitigated by diversifying across many loans.

To build a good portfolio, one ought to diversify. All forms of investments have risks, advantages, and disadvantages – which is why it is imperative to balance risk and reward across many asset classes to protect your investments. After all, your investment portfolio is vital – it is your retirement income.

This article was first posted on the blog of our sister company Funding Societies (Singapore). Click here for the original article.

This article was written by Funding Societies, the first P2P financing platform to launch in Malaysia. We provide working capital financing for small and medium-sized enterprises (SMEs), along with attractive investment opportunities to the broader public. To learn more about us, click on our website here.