Diversification is one of the very first things that an investor, whether professional or beginner, needs to do in order to achieve investing success. There are many reasons why diversification is important.
It’s quite impossible to get rid of risks totally. The key is to manage the risk level that you’re taking. Every investment has some risks that are inherent to it, no matter what type of asset it is. If you’re a young investor, you must embrace such risks since the long term rewards can make all those risks worth it.
Meanwhile, for older investors, risks are not so good. That’s because too much risk can wipe out all their plans for their retirement. During the most recent economic downturn, many senior citizens incurred great losses in their retirement portfolios.
There are investors who failed to diversify among other assets, making them too exposed to stock market risks. Diversifying into safer fixed income assets could have prevented some losses and reduced their risks while maximizing their returns. Using capital preservation and diversification in your investment strategies can also minimize the investment portfolio risk.
Most investors try to achieve capital appreciation, while some others instead use capital preservation as part of their strategy. Capital preservation enables you to protect and safeguard the capital that you have. You don’t have to focus too much on the rate of return. With diversification, protecting your capital becomes a lot easier.
Investing in a variety of assets diminishes risks particularly when investing in a limited number of stock. You can try lessening the impact of riskier assets on your portfolio by diversifying in different investments.
Aside from investment risk management and capital protection, you can hedge your portfolio as you use diversification as a strategy.
Hedging your Portfolio
Diversification can enable your portfolio to grow both when the market is upbeat and when it is bearish. Investors who chose to invest 100 percent of their capital to equity portfolio have likely seen subpar returns. If they branched out and diversified into other assets like metals, bonds, commodities, and currencies, their portfolios could have achieved better or positive returns in one market when the other crumbles.
But what makes a Portfolio Diversified?
Basically, if you want to diversify your portfolio, you have to spread your capital across different asset classes to reduce your overall investment risks. That means you include both aggressive and defensive assets.
Growth/aggressive assets include investments like shares or property, providing capital gains for the longer term. However, these assets also have higher degree of risks when compared with defensive stocks.
Defensive assets are investments like cash or fixed interests. They generally offer lower returns over the longer term but they also generally have lower levels of volatility and risks when compared with growth assets.
To diversify your portfolio, you have to spread your risks across different asset classes (cash, fixed income, currencies, foreign equities, etc) as well as within asset classes, like buying different stocks across different sectors and industries. If you’re investing in funds too, you have to invest across different fund managers.