Diversification is one of the very first advices that a rookie trader and investor would get. Not surprisingly, it’s also one of the most beneficial tips that you could ever follow. It is important to diversify not only because it’s a rule of thumb, but also because it offers a lot of advantages to your portfolio.
Learn first about investments
But before you diversify, it pays to note that you should first learn as much as you can about the investments you can put into your portfolio. Like what Warren Buffett always says, never invest in something you don’t understand.
That means before you include an asset in your portfolio for the sake of diversification, master that asset first. Understand everything there is in it, like its profitability, its price behavior, its sensitivity to different factors, et cetera.
This way, it will be easier for you to know how it would affect the overall performance of your portfolio. You will also know how many units of it should make up a portion of your portfolio. Knowing how an investment completely works is knowing the future profitability of your portfolio.
Why should you diversify?
For investors, there are two main reasons to diversify. First, diversified portfolios incur lower amount of risk than concentrated portfolios. Second, diversification enables you to add riskier types of assets to your portfolio without increasing the overall risk your portfolio has to handle.
It doesn’t take a math whiz to understand why a diversified portfolio has less risk than one that’s not diversified. It’s basically not putting all your money in one wallet. That’s a derivative of not putting all your eggs in one basket.
For instance, think of a portfolio that’s 100 percent dedicated to stocks. if something happens to the stock market—a market correction, market crash, or downright alien invasion—the portfolio will suffer heavily. You will lose your entire investment. And that’s something you don’t want to happen, do you?
Now think of a portfolio that’s diversified across various assets and industries. It contains equally sized positions in 5 industries. If one industry unfortunately experienced a major slump, only 1/5 of your portfolio will suffer losses. And those losses may still be offset by the gains in the four other industries you invested in.
What ways can you use to diversify?
Lucky for investors, there is a plethora of ways to diversify. The most common is via the use of mutual funds and exchange-traded funds. Such funds enable you to invest small amounts of money. Your investments will then be pooled with those of thousands of other investors.
The fund puts together all the shareholders’ savings so it’s able to buy dozens or hundreds of different investments.
Meanwhile, you can also create your own diversified portfolio by mixing a number of individual stocks, bonds, or other investments. Generally, buying stocks that differ in size, industry, geography, and corporate strategy can help you maximize the benefits of diversification. Conversely, when you focus on similar stocks in the same sector adds low diversification to a portfolio.