Why is portfolio diversification essential?
Whether investing, walking down the street, driving or watching the sunset from the balcony, you are always taking a risk. Your personality and lifestyle play a key role in the risks you are able to take. Therefore, in this post, we will explain what diversification means and how you can diversify and gain greater rewards.
What is diversification?
Diversification is a risk management strategy that combines investments in a portfolio. When the market is growing, it seems impossible to sell a stock for any amount less than the price for which you bought it. Since the market is unstable, it is important to have a diversified portfolio.
We can better explain the meaning of diversification with the proverb: “Don’t put all of your eggs in one basket.” If we drop the basket, we will break the eggs. In other words, placing the money in different assets is more diverse and safer. This means, according to the proverb, that there is more risk of losing an egg, but less risk of losing all of them. However, having a variety of baskets can increase costs.
In addition, a diversified portfolio has a mix of assets such as stocks, commodities, real estate, lending, etc. And diversification works because all of these assets react differently to the same economic event. Different investments will provide a higher return. That’s the idea.
“My ventures are not in one bottom trusted nor to one place; nor is my whole estate upon the fortune of this present year. Therefore, my merchandise makes me not sad.” — William Shakespeare, Merchant of Venice.
So, as we can see from Shakespeare’s quote, in any portfolio, one investment may do well while another does poorly.
Theoretically, diversification allows you to reduce the risk to your portfolio without losing possible returns. And a well-organised portfolio has the lowest possible risk for a given return. If your portfolio is too diversified, you will need to take additional risks to achieve a greater potential return.
Why you should diversify
The purpose of diversification is not to obtain very high returns. Gains are not guaranteed and losses may occur. Nevertheless, this method does have the potential to get you better returns with any level of risk that you choose. So, here is a list of reasons you should diversify:
- The efficiency of the investment depends on its type;
- You can create a portfolio, in which the overall risk is smaller than the combined risks of the individual assets;
- The investments are affected in different ways by world events and changes in economic factors (such as interest rates, exchange rates and inflation rates);
- You are taking a greater risk if you don’t diversify your portfolio. The average return will not be guaranteed at a higher rate if you take an unnecessary risk.
Diversification: 5 things you need to know
If you would like to have a diversified portfolio, you should look for different investments with different origins. This way, even if some assets are declining, the rest of them should be growing, or at least not declining that much.
In order to help you with diversification, here are five things you need to know:
1. Continue to build your portfolio
Don’t forget to add to your investments on a regular basis. Follow the market so you arenot caught in its inherent volatility, and minimise your investment risk by investing the same amount of money over a period of time.
2. Never put your money in only one place
It is important to minimise the risk and the uncertainty, so don’t put all of your money in only one place (i.e., one stock or one sector). If you invest in different assets, you will spread the risk into tiny fractions, and consequently, can earn greater rewards.
3. Look for commission / hidden costs
Be aware of hidden costs when you trade or when you invest in one asset. Monthly fee or transactional fees are a few examples of what you should be looking out for and that keep adding up, scraping away your gains. It is important to pay attention to what you are getting for what you are paying. In other words, what you are getting for the fees you are paying.
4. Notice when to get out
The market is always changing and you must keep an eye out for it, because the changes can be very sudden and you do not want to be caught in the landslide. It is important to know when it is time to cut your losses, sell and move on to the next investment.
5. Think about adding index or bond funds
If you are planning on using diversification in your portfolio, it is a good idea to add index funds or fixed income funds to it. Investing in assets that track various indexes makes a great long-term add-on for your portfolio.
What you should know so far
To achieve your long-term goals, there are always some risks that you need to take, but they do not have to be unnecessary. As described above, diversification can play a larger role in these long-term plans. It is also important to choose the right combination of investments, keep an eye on it and nourish it. This will make a big difference in your results.
Regardless of your purposes, your time horizon or your risk tolerance, a diversified portfolio is the basis of any smart investment strategy.
Paulo Carvalho De Sa is a Popular Investor on eToro who uses fundamental and technical analysis to make trades, and believes that patience is the key when investing. He has over 130 copiers and almost 4,000 followers.
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