Why You Need to Diversify Your Investments
While it’s no secret that putting your money into investments is an excellent way to make it grow, there are other strategies you can use to maintain high, sustainable returns while reducing risk. A popular technique called diversification lowers this risk by funneling your money into different investments across various financial industries, instruments, and more. By diversifying your investments, you’ll maximize your returns since each area would respond differently to the same event.
Although diversification does not entirely protect you from loss, it mitigates some of that risk while helping you achieve your long-term financial goals. Here’s what you need to know about diversification and how it can help you build your wealth:
How Diversification Works
To understand how diversification works in investing, let’s say you have a portfolio that only has stocks in fast food chains. However, bad news about them hits the news, workers go on strike, and people start avoiding these chains due to the negative press. As a result, your portfolio will see a drastic drop in value.
You can offset these stocks by investing in other food and beverage companies, which means that only a portion of your portfolio is negatively affected by this. In fact, due to these circumstances, stock prices may rise, especially as customers start looking for alternatives to their cravings.
It’s best to diversify because of the risks associated with these businesses, as anything that affects the food and beverage industry will hurt your investments. The less connection your stocks have with each other, the more insulated they’ll be from price drops. You’ll also want to diverse in different asset classes, as bonds and stocks don’t have the same reaction to adverse events. Combining these asset classes protects your portfolio and reduces its sensitivity to market swings since they react to different scenarios. It is also best to look for opportunities in other parts of the world, as volatility in one place is unlikely to affect another.
The Number of Stocks You Should Have
While owning six stocks is much better than owning just one, having too many stocks won’t significantly affect your portfolio. There is a lot of debate surrounding how many stocks you need to maintain a high return while keeping risk at bay, with convention stating that optimal diversification is achievable with 15 to 20 stocks in various industries.
The Types of Risk
Investors face two types of risks when they invest. The first is systematic or market risk, which is found in every company. These causes include exchange rates, interest rates, political instability, war, inflation rates, and more. It is impossible to eliminate this risk through diversification, which means that all investors must be willing to accept this risk.
The second type is diversifiable or unsystematic, specific to a particular company, market, industry, economy, or country. Common sources of this risk include business and financial risk. Since it is diversifiable, investors lessen their risk by diversifying their investments to mitigate the effects of various market events.
Potential Issues with Diversification
Most investors praise diversification and its importance when investing, but it also has a few disadvantages. For starters, managing a large number of investments can be unwieldy, mainly if you have numerous holdings and investments. Diversifying your portfolio can also be expensive, as investment vehicles have different costs, which means buying and selling will negatively impact your bottom line due to transaction fees and brokerage charges. Diversification can also be complicated, particularly for beginners or small investors.
A diversified investment portfolio comprising different asset classes like stocks, bonds, and other securities from various industries can help offset the impact of market swings. However, it’s important to note that regardless of how diversified your portfolio is, it is impossible to eliminate risk, but it can certainly reduce your exposure to it.
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