Diversification in investing means to lower risk by putting money into different financial instruments, industries, and other groups. It tries to keep losses to a minimum by investing into different areas that would respond differently to the same event.
Most investment experts agree that diversification is the most important way to reach long-term financial goals while minimizing risk, even though it doesn’t guarantee that you won’t lose money. Here, we’ll look at why this is true and how to make sure your portfolio is diversified.
What is diversification in investing?
Let’s say that all of the stocks in your portfolio are from oil companies. If some global geopolitical trend causes oil demand to drop, stock prices will go down. If that happens, the value of everything you own will go down. But if you have already put in shares from, say, the renewable energy sector, only a portion of your portfolio will be affected. Even more likely, as the world moves away from fossil fuels and toward renewable energy, stocks in the renewable energy sector will rise, making the portfolio’s value more or less even.
Diversification is all about making sure that your investments are evenly spread out across your portfolio. When you diversify, you don’t try to make the most money by investing in the most profitable companies. Instead, you take a defensive stance.
How to diversify investing well?
Whether you are new to investing or have been doing it for a while, you should learn about diversification. First, you should choose investments based on how much money you have, how much you expect to get back, how much risk you can handle, and how long you are willing to wait.
Invest in different assets
The share price, foreign exchange rate, and property value of a company don’t all react the same way to market trends. If you put your money into more than one type of asset, you can be sure that if the price of one asset goes down, it won’t hurt the others, and some of them might even go up. For example, if a country’s currency loses value, it could make a company more competitive abroad. This could cause the price of its shares to go up, which would make up for the loss on the investment in that currency.
Invest in different industries
People often mistakenly think that diversifying means investing in different companies, no matter what industry they are in. That could turn out badly, because if you buy shares in three companies in the same industry, new rules, a natural disaster, rising production costs, and other things that could affect it are likely to lower the value of the companies’ shares. There are many ways to invest in different fields that aren’t directly related, such as transportation, banking, technology, real estate, and manufacturing.
Diversify geographically
Most of the time, people invest in their own country or region because it seems safer and more familiar. Still, it’s a good idea to spread out investments geographically by looking for alternatives in countries with good economic prospects. In that case, you should think about things like inflation, changes in government, new economic laws, and even natural disasters and war. It could be helpful to work with a professional or an investment fund to make a plan for your investments. Investing in different regions can reduce risk, just like investing in different assets and industries, because economic ups and downs don’t usually affect all countries in the same way.
Change the lengths of time
One way to classify investments is by how long it takes for them to pay off: short term (up to a year), medium term (up to five years), and long term (more than five years). In general, the risk is lower and the return is higher when the term is shorter. Long-term investments tend to have more risk, but they also pay off more. Diversifying the lengths of the investments helps lower risk, but investors need to think about their own liquidity needs and expectations. For example, you could choose to invest in medium- and long-term assets if you are saving for retirement and don’t need the money right away.
How many stocks should you have in your diversified portfolio?
There is no magic number of stocks you need to hold to keep from losing money. Also, you can’t get rid of all risks in a portfolio. There will always be some risks that come with investing that you can’t get rid of with diversification.
People have different ideas about how many stocks are needed to lower risk and keep a high return. Most people think that an investor can get the most out of diversification by buying 15 to 20 stocks from different industries. Some people don’t agree that 30 different stocks is the best number to own.
Index funds are a great choice for investors who might not be able to afford holdings in 30 different companies or traders who want to avoid the transaction fees that come with buying that many stocks. By holding this single fund, you get a piece of all the companies, securities, and holdings that make up the index, which can be dozens or even hundreds of different ones.
Pros of diversification
Diversification is not a surefire way to make your portfolio worth more money, so it’s important to think about both the pros and cons of this investment strategy.
Protection against losses
This is especially important for older investors who are nearing the end of their careers and need to keep their money safe. It’s also important for retirees or people who are getting close to retirement and may no longer have a stable income. If they depend on their portfolio to pay for their living costs, they need to weigh risk over returns.
Increasing the returns
Diversification is thought to increase a portfolio’s returns relative to its level of risk. This means that investors get bigger returns when the risk they are taking is taken into account. Investors may make more money from riskier investments, but a risk-adjusted return is usually a measure of how well their money is being used.
Creating better opportunities
Some people might say that diversifying is important because it gives you better chances. Let’s say you invested in a streaming service to get away from transportation companies. Then, the streaming company makes a big content investment and partnership announcement. If you hadn’t been spread out across different industries, you wouldn’t have been able to take advantage of good changes in different fields.
Making it more fun to invest
Last, for some, diversifying can make investing more fun. Diversifying your investments means that you don’t put all of your money into a small group. Instead, you research new industries, compare companies against each other, and emotionally buy into different industries.
Cons of diversification
Diversification is something that professionals always say is important, but there are some problems with this strategy.
Hard to deal with
First, it can be hard to keep track of a diverse portfolio, especially if you have a lot of investments and holdings. Modern portfolio trackers can help you report and summarize your holdings. But, if you have a lot of holdings, it can be hard to keep track of them all. This also includes keeping records of what was bought and sold for tax purposes.
Diversification can also cost a lot of money. Not all investments cost the same, so buying and selling will affect your bottom line. This will include from transaction fees to brokerage charges. Also, some brokerages might not have the asset classes that you want to hold.
Complicated
Next, think about how hard it can be. For example, investors’ different levels of risk tolerance have led to the creation of many synthetic investment products. Most of the time, these products are hard to understand and aren’t made for new or small investors. Diversifying a portfolio can be scary for people who haven’t invested much before or don’t have a lot of money.
Won’t stop a loss
Even the best analysis of a company’s financial statements can’t guarantee that investing in it won’t be a bad idea. Diversification won’t stop you from losing money, but it will make it less likely that fraud or bad information will hurt your portfolio.
Not all risks can be spread out
Last, you can’t diversify away some kinds of risks. Think about how the COVID-19 pandemic affected the world in March 2020. Due to uncertainty around the world, stocks, bonds, and other types of investments all dropped at the same time. Diversification could have helped lessen some of those losses, but it can’t stop all losses.
Bottom line
Diversification can help an investor manage risk and make price changes less volatile. But remember that risk can never be completely removed, no matter how diversified your portfolio is.
You can lower the risk of individual stocks, but general market risks affect almost every stock. So, it’s also important to spread your investments across different asset classes, countries, security durations, and companies. Finding a good balance between risk and return is the key. This makes sure that you can reach your financial goals and get a good night’s sleep.
