Diversification is the distribution of risk among different types of investments with the aim of increasing the chances of investment success. It's like saying that no one can know for sure who will win this race, let's bet on everyone.
Diversification is essential for investing as markets can be volatile and unpredictable. By diversifying your portfolio, you “reduce the impact of a misprediction,” says Ryan Nauman, market strategist at Informa Financial Intelligence’s Zephyr.
In practice, diversification refers to the ownership of investments that will react differently to the same market or economic event.
For example, when the economy is growing, stocks tend to outperform bonds. But when things slow down, bonds often hold better than stocks.
By owning stocks and bonds, you reduce the chances that your portfolio will be hit hard by market fluctuations in one direction or another.
Amin Dabit, a certified financial planner and director of advisory services at Personal Capital, uses the fruit stand analogy to explain diversification: As a salesperson, you would like to “sell different fruits instead of one, so if a major unforeseen event like a hurricane destroys orange groves in Florida, you can also make money selling apples from the northeast or bananas from Hawaii, ”he says.
Also, it would be wise to use different suppliers of oranges so that if you run into problems with one supplier, you are not left without oranges.
Think of these different types of fruits as the different tools, techniques and sectors available to investors, he says. "With a wider range of products, you are better protected from the risks that could affect any of them."
Diversification can go further than simply diversifying investment instruments.
“For us, diversification also means the composition of the teams that manage our money, not just the investment itself,” said Liesel Pritzker Simmons, co-founder of the Blue Haven Initiative, a family-owned business center in Boston dedicated to social investment. "If all of your fund managers attended Harvard Business School from 1985 to 1992, they will have a certain worldview that they share, no matter how diverse their fixed assets are."
You may have heard of diversification, which is called the only "free lunch" in investing. “This is because improving returns is key to wealth and portfolio growth over time, and avoids big losses,” said Kent Inslee, chief investment officer at Tiedemann Advisors in New York. "An investment that drops in value by 50% must rise 100% to recoup its original value."
While certain asset classes may experience a sharp drop. Experts say: "It is very rare that two or three assets with very different sources of risk and return, such as government bonds, gold and stocks, will experience a drop of this magnitude at the same time."
So even if stocks are down 30%, your bonds and gold will prevent your portfolio from dropping as deep as expected. Therefore, diversification is important in your investments.
The benefits of diversification include the following:
- Minimizes the risk of losing the entire portfolio.
- Provides you with more options for your return on investment.
- Protects you from adverse market cycles.
- Reduces volatility.
The benefit of diversifying your investment is that it minimizes the risk that a bad event could wipe out your entire portfolio.
If you hold a high percentage of your portfolio in one type of investment, you risk losing it if the investment fails.
There is also a “diversified opportunity price”. "If you are not diversified, you may be missing out on growth opportunities in a different asset class that you do not work with."
It is difficult to hold onto money when there is a slowdown in growth – or worse, on a decline in the price of an asset, when your other investments are making much more money. But it is important to remember that today's star may fall tomorrow.
“During a bull market, it is easy to forget that the market loves surprises. The best defense against market cycles is a diversified and long-term portfolio orientation. "
As your investment goals or timeframes change, "the leverage should be based on how aggressively the diversified portfolio is being built," say fund managers.
Investments aimed at long-term goals may rely more on stocks than those aimed at achieving short-term goals. But even if you own 80% of the shares, you must diversify by sector, region, and size.
An important part of diversifying your investments is keeping track of your investments. For all your investments, you can use various internet services such as finance.yahoo.com, Investing.com, etc.
How to diversify your portfolio
Contrary to popular belief, diversification is not a numbers game. Whoever owns the most investments does not necessarily win the top prize. The trick to diversifying your portfolio is to own investments that play different roles in your team.
There are several ways to diversify your portfolio, but the same rule always applies:
Each investment in your portfolio should serve a different function.
For example, to diversify stocks, you might have an S&P 500 index fund or an RTS index for large-cap stocks and another focused on small-cap stocks. You need Russian and international companies, as well as representatives of all market sectors.
Your bond portfolio should be equally diversified with “short-term and long-term bonds, corporate and government bonds, to help reduce the risks associated with fixed income products.
When stocks and bonds get stuck in place, alternatives can start or continue moving. They are like taking an escalator rather than an elevator to get to your destination. With alternative investments in your portfolio, you are unlikely to get stuck between floors.
How to know if your portfolio is diversified
An easy way to determine if your portfolio is diversified is to look at your current performance. Diversified investments will not move in the same direction at the same time. If some investments grow and others fall, then you have diversification.
Think of diversification like a Christmas tree: Red and green combined mean you will be beautiful whatever the weather.