|The Importance of Portfolio Diversification|
For any investor, new or veteran, diversification is the key to protecting your portfolio. Through diversification, you systematically reduce the risk to which you are exposed at given times. The basic idea behind diversification is to split up your finances into different investment types and industries. The best strategy is to invest in areas that would respond differently to market changes – if one investment is not profitable, your portfolio makes up for the loss with other investments. While there is no risk-free strategy to investing, diversification is as close of a guarantee you can get.
The inherent risks of investing
There are two main types of risk that you are exposed to when investing. Un-diversifiable, or systematic risk, is a part of every company. Changes in inflation, exchange, and interest rates are part of this category. These risks are the same across the market, and thus, there is no action you can take to eliminate them.
On the other side of the spectrum are diversifiable or unsystematic risks. Business and financial risks are a main part of this category. These risks can be specific to a company, an industry, or a market. By diversifying your portfolio, you can dramatically reduce these risks.
Why diversifying is critical for your portfolio
If your portfolio is comprised of only one type of stock, and the share price drops dramatically, your portfolio could take a serious hit. Depending on how quickly the market turns around, it can take months or even years to recoup your losses.
However, if you have your portfolio diversified in several types of stocks, only the ones affected by the price drop will lose money, and the profits from the other shares can help balance out the money lost. To diversify most effectively, it is ideal to not only choose stocks from different companies, but different industries as well. You can also diversify across different countries, shielding you from the risks of changes in the domestic economy.
Even further, you may consider what would happen to your portfolio if you have only stocks, but the market crashes. Like many of the Black Friday and Black Monday stories, you could end up losing all of your financial savings. However, by investing in another asset class, such as bonds or real estate, you can protect yourself from this dangerous risk. For example, in many instances, if stocks plummet, bonds increase in value, and vice versa. Therefore, the two can help balance each other out and lower your risk.
For advanced investors, there are other ways to diversify, depending on the amount of risk that you have or are willing to tolerate. While diversifying will not protect you against all potential for loss, it can make your portfolio significantly more stable and help offer you some security.
There is a risk of over-diversifying. Owning five different financial instruments is better than just one or two, but investing in too many can impact your earnings because of dilution. Many individual stock investors feel that an average of 10 to 20 stocks, spread over different industries, is enough diversification. Through proper and sufficient diversification, you can reduce your risk levels and protect your overall portfolio against significant changes in the market.