When learning how to invest your money properly, you may have heard of something called diversification. Diversification is important in investing because it helps protect your returns from poor market conditions.
If you're anything like me, you probably shudder at the thought of investing your hard-earned money. In fact, I often felt that saving money in the bank was way better than investing and risking losing it all. That was until I realized that diversification is one of the most effective risk management strategies an investor can learn!
Diversification Is Important In Investing Because...
Above all else, diversification is important in investing because it means you’re not putting all your eggs in one basket. Instead, it allows you to spread your financial risk across many different types of investments. With diversification, you can reduce the chance of one bad event taking out your entire portfolio. Here's exactly why diversifying your portfolio is so important:
It Helps Minimize The Risk Of Loss
Even though diversification doesn’t eliminate all investment risks, it does help manage them. For example, let’s say you own stocks in industries like electricity, banking, food production, and insurance. Chances are, these shares will all perform pretty independently.
That means your stocks won't all be moving in the same direction at one time. So when one industry, like insurance, hits a rough patch, your portfolio probably won’t suffer much overall.
It Helps Balance Risks And Rewards
High performing investments will provide a cushion for those that perform poorly. Diversification is important in investing because it helps shield you from drastic changes to your cash flow. Keeping a diverse portfolio won't always protect you from a major sector crash. But it can help soften short-term drops in stock prices.
It Helps Preserve Capital
To become a successful investor, you’ll have to go through a learning curve. This experience will help you make better investment choices that are suitable for your level of risk tolerance. A young investor will have more time to recoup major losses.
On the other hand, an investor close to retirement won’t have time for risky mistakes or long-term investment plans. Instead, their investment goals will need to shift toward preserving capital. In both of these cases, diversification will help protect invester savings.
What Are The Different Types Of Risks?
As you might have noticed, diversification is important in investing because it helps manage risk. But what risks should you actually be worried about? Risks can be classified into two main categories: First, there are systematic risks. These risks are a natural part of the market that all investors must accept. These risks include exchange rates, inflation rates, political instability, interest rates, and war.
Second, there are unsystematic risks. These risks are specific to a company's, sector's, or country's financial performance. Fortunately, all of these risks can be reduced through diversification.
How You Can Diversify Your Financial Portfolio
A diversified portfolio involves limiting risk by investing in different asset classes, sectors, industries, and even geographic locations. However, it's not enough to just diversify your portfolio across one or two of these categories. Here are the most important types of diversification every investor should know:
Your portfolio is balanced when your investments are spread across different asset classes. That way, if one sector underperforms, you'll still have others to help you pull through. There are four main asset classes — stocks, bonds, cash equivalents, and real estate. The amount you devote to each asset depends on your tolerance for risk as well as your investment time frame.
You can always readjust your options to meet your investment goals later on. For instance, a bond is a loan given to a company or the government with a fixed interest rate and duration. While bonds don't provide higher returns than stocks, they are less volatile. Because of this, bonds offer a great cushion against the unpredictable stock market.
A sector is a specific group of stocks within a particular economic market. Some of the main sectors in the investment world include:
Investing heavily in one sector could result in a major blow to your overall finances when that part of the market drops. For instance, investors who held huge bank stocks back in 2008 saw their net worth drop drastically during the financial crisis.
During portfolio selection, it’s worth noting that you can diversify further within each sector. For instance, in the healthcare sector, you have the option of investing in companies that produce medicine, design medical equipment, or perform diagnostic research.
Security diversification involves increasing different stocks in your portfolio to reduce risk. However, the question is, how many stocks should you own to become well diversified? For maximum security, it's best to invest in funds. These funds pool money from different investors and allow them to buy a large number of investments in a single transaction. These funds include:
By investing in one of these funds, your portfolio will instantly become more diverse.
Geographic diversification means developing a portfolio with both international and domestic stocks. These portfolios have lower risk levels than those invested exclusively in domestic or international stocks. This type of diversification is important in investing because of the role things like politics, natural disasters, and local economies can play in the market.
Investment Style Diversification
Investment style diversification refers to how you manage your portfolio. There are three main investment styles: The first one is called the value approach. This method seeks out companies that seem undervalued by the current market.
Second, the growth approach involves identifying companies that may grow faster than the market average. Finally, the indexing approach takes a more neutral turn and tries to replicate a market index. For example, you can mirror the performance of the S&P 500 by holding stock of companies within that index.
Market Capitalization Diversification
Market capitalization is the total value of a company’s stock shares and measures the worth of the company on the open market. It’s calculated by multiplying the price of one share by its number of outstanding shares. For example, a company with 20 million shares selling at $25 a share will have a market cap of $500 million.
Large-cap companies have a market value of $10 billion or more. These investments are considered less risky, but they also have less aggressive growth potential. On the other hand, mid-cap companies have a market value between $2 billion and $10 billion. Investments here are less risky than small-cap companies and offer more growth potential than large-cap companies.
Finally, small-cap companies have a market value of $300 million to $2 billion. Their relatively limited resources make them vulnerable to intense competition and economic downturn. However, these businesses offer significant growth potential for long-term investors.
Now It's Your Turn
Diversification is important in investing because it can help you achieve consistent long-term returns. As you have likely noticed, there are numerous ways to hedge your investment portfolio. However, you should always do thorough research and invest in areas of which you're knowledgeable.
Overall, remember to pay attention to your investment objectives, financial circumstances, and risk tolerance before considering the market's past performance. That's because in investing, past performance doesn’t always dictate future results. What's your favorite method for investment diversification? Let us know in the comment section below.