There’s no sure thing when you invest, but there’s one practice that can get you as close as possible to a sure thing and that’s diversification. Without diversifying your portfolio, you put yourself at risk of losing everything.
It’s like putting all your eggs in one basket. If you invest all your money in one stock, for example, what happens when that stock crashes?
You lose everything.
But, if you diversified, you’d offset that risk and set yourself up for greater success.
What is Diversification?
Diversifying your portfolio means spreading out the risk. We all know the stock market is risky. There’s no guarantee it will go up or down – no one can 100% predict what the market will do.
When you diversify your investments, you spread out your risk, putting your money in various investments that each will react differently to the same market. For example, a technology stock will likely react differently than a healthcare stock in certain situations because they are in two different industries.
No two industries or assets react the same to the same risks. Spreading your money across a variety of investments helps reduce your risk of loss.
Benefits of Diversification
1. Minimize your Losses
No one can completely minimize their losses when investing because without risk, there would be very little return. But, when you diversify, you reduce the risk of a total loss. You won’t have everything invested in the same asset, so if it crashes, you won’t be at risk of losing everything. Your other assets may even react differently, offsetting the loss altogether.
2. You Reduce the Risk of an Opportunity Cost of ‘Missing Out’
If you don’t diversify, you may miss out on a potential large return. Putting all your money in one investment has an opportunity cost of investing in other assets. But when you diversify, you broaden your investment horizons and expose yourself to assets you may have otherwise ignored.
3. You can Preserve your Capital
If you’re nearing the end of your goal’s timeline, the last thing you want is to risk everything right now. If you put all your eggs in one basket, you could lose everything in one fell swoop. But, if you diversify, you preserve your capital by offsetting a total loss. This ensures you will meet your goal or at least be close to it without risking a total loss.
4. You’ll have Multiple Sources of Income
Relying on one source of income is risky, even if we’re talking about employment. What happens when the rug is pulled out from underneath you and you’re left with no income?
The same is true of investing. If you rely on one investment for your income, you could be sorely disappointed and walk away with nothing. If you rely on multiple sources of income, though, you have a higher chance of walking away with a gain.
5. You Increase your Chance of Larger Profits
When you diversify your portfolio, you broaden your horizons and increase your chances of larger profits. For example, if you look outside of domestic investments and add global investments to your portfolio, you may realize larger gains than if you stuck within the US boundaries.
How to Diversify your Portfolio
Now that you know the benefits of diversifying, it’s important to understand how to diversify your portfolio.
It’s not a race to see who has the most investments. Just because someone has a lot of investments doesn’t mean they are diversified. Instead, focus on where you invest your money. Look at the type of asset and the industry.
For example, if you invest in stocks – diversify your money across large cap and small cap stocks. Even within those categories, diversify your money amongst different industries as no two industries react the same to the same market information.
You may also want to include less risky investments in your portfolio, such as bonds or treasury securities. If you do, continue the diversification process by investing in both short and long-term bonds or securities.
How to Tell if you Diversified your Portfolio
Even if you feel like you diversified your portfolio, there are certain signs to look for to tell for sure.
When you look at your portfolio do you see everything moving in the same direction or is your portfolio all over the charts? If you answered all over the charts, you’re doing it right. When you invest in different assets, they won’t perform the same as one another. Some may increase and others decrease based on the market’s performance – that’s a sign of true diversification.
On the other hand, if your chart looks fairly uniform, you didn’t diversify your investments enough. You’re at a high risk of a total loss because you have everything invested in one type of asset or assets that are so similar, they react the same.
If there’s one thing you learn about investing, it should be to diversify. No matter how much or how little you know about the market, knowing that you should spread your money across several investments is important.
You’ll offset the risk of a total loss and you may even see larger gains. When you try different investments, you may take risks that you otherwise wouldn’t have tried, leaving you open to even greater returns.
While diversification isn’t a sign of a ‘sure thing,’ it lowers your risk of a total loss and is a smarter way to invest. It will expose you to assets you may have otherwise overlooked and who knows, it could be the investment that helps you reach your financial goals.