“Don’t put all your eggs in one basket” is a popular saying we’ve all heard and it very much applies to the concept of diversification in investments.
If eggs represent your money, then you can see baskets as asset classes.
Asset classes are simply different types of investments such as stocks, bonds, cash, or money market instruments.
When you invest in a stock, for instance, you are taking a risk. However, one way to manage that risk is by diversifying your stock portfolio.
In this article, we explore what diversification means in investing, its benefits and other crucial things to know.
Jump to a section:
- What is portfolio diversification?
- Why diversification is important?
- Advantages and disadvantages of diversification
- How to diversify your portfolio
- How to avoid over-diversification
What is Portfolio Diversification?
Diversification of investment portfolio is strategically putting the mix of eggs in each of your baskets i.e how you distribute your money across several investment types.
All investments involve risk; it is, therefore, necessary to know how to manage or mitigate the risks.
Diversification of risk allows you to reduce your risk by spreading your investments across different assets. It’s one of the simplest ways to withstand market fluctuations and retain the ability to expand your investments.
Why diversification is important?
The risk that each asset carries is different and so are its returns. So if some asset classes don’t perform well, others might and this helps to cushion your portfolio against unpredictable crashes.
Diversification allows you to reduce your risk without reducing your return. You get to enjoy perks such as better possibilities, learning about new assets, and higher risk-adjusted returns.
Diversification is important because it helps to lessen the risk that comes with investing in a single asset.
Advantages and Disadvantages of Diversification
Advantages
- Diversification gives you a sense of security even if some stocks go out of business.
- It allows you to manage risk while building your portfolio.
- It’s an opportunity for growth as it exposes you to opportunities in different sectors. You get more gains, especially in a thriving sector.
- It reduces the effect of market volatility. The market is unpredictable and companies can go bankrupt. However, with diversification, you can rest assured that not all companies will liquidate.
- It helps you pay more attention to the stock market. Normally, navigating the stock market can be complicated and takes expertise. With a diversified portfolio, you start to pay attention to market trends that help you make better investment decisions.
- You don’t need so much money to start. With minimal investment, a stock or bond mutual fund or exchange-traded fund (ETF) can provide considerable diversification.
Disadvantages
- If one of your investments gets profit or interest, you won’t make as much if it was your sole investment.
- Due to the varieties in your portfolio, it can be hard to monitor or pay attention to individual investments especially if you don’t have someone handling them for you.
- There’s a thing called over-diversification. Over diversification occurs when each additional investment made to a portfolio decreases expected returns by a wider margin than the matching decline in risk. This means, at that point, there is nothing beneficial about any new investments added.
- Diversification can get overly complicated, especially for investors that don’t understand what it entails.
- Average returns are also a disadvantage. When you hold both good and bad investments, value tends to diminish and you get low to average returns.
How to diversify your portfolio
One of the best ways to achieve portfolio diversification is through mutual funds.
Mutual funds are investment entities that pool funds from investors to invest in diverse securities such as stocks, bonds, and money market instruments.
A best practice is to ensure that most of these securities are unrelated. So if one goes down or bankrupt, they won’t all go down together.
Have a mix of investments in companies in different countries. Aim for international or multinational stocks. Own stocks in small and large companies, and invest in a variety of industries.
Avoid having a substantial amount of your assets in a single stock. Look for funds with low fees and spread them across many investment vehicles. An example is index funds; this is a low-fee fund that mimics a large stock like the S&P 500.
Unlike traditional investments like stocks, bonds, cash and cash equivalents, a modern diversified investment also include alternative investments such as real estate, private equities, hedge funds, managed futures, art and antiques, commodities, and derivatives contracts.
Portfolio diversification can be achieved through proper asset allocation, knowing your risk tolerance and determining what type of assets are going to be in your portfolio.
How to avoid over-diversification
- Keep your portfolio to a manageable minimum.
- You do not need to buy every investment that presents itself to you, no matter how promising it seems.
A portfolio that is too diverse is a portfolio that is most likely heading for losses.
Bottom line
A diversified investment will contain a balanced collection of stocks, bonds, mutual funds, commodities and other investments across unrelated industries.
Building wealth is great. However, not every investment is meant for you. Know your risk tolerance level and financial strength before diving in.
Additionally, it is impossible to eliminate all risks from a portfolio because investing always carries some level of risk that cannot be completely eliminated through diversification.
RELATED:
The Impact of Diversification on Portfolio Performance: A Case Study of The 2008 Financial Crisis
