Why Diversification is Important in Investing
Do you remember the time when you used to play hide and seek with your friends as little kids? The rule was for everyone to hide in different spots available within the neighborhood so that even if one or two players got out, the others will still have the chance to win the game. Well, that is what diversification all about.
Tomorrow is never promised, the future is unpredictable so diversification is immensely vital in investing. It is laying out your risk to different types of investments to increase your success, which is the goal in mind. Diversification is like saying that since no one knows for certain who is going to win in a tournament, then it's a must that we do not bet on just one but on other teams, as well.
When it comes to investing, diversification is a must since markets can be uneasy and unpredictable. For example, if you have a fruit stand, you have to sell different kinds of fruits so that if a super typhoon hits the banana plantations for example, you can still make money by selling sweet mangoes. And it would be wise to use different suppliers of mangoes as well so that if one of them has a problem with the delivery, you will not be left without a mango to sell – that explains diversification.
Benefits of Diversification:
- Minimizing risk of loss – when one investment performs badly in a certain period, through diversification the other investment may perform at a better shape in that same time. It minimizes your potential loss (of your investment) from concentrating all your capital under one kind of investment.
- Preserving capital – Well, not all investors are in the stockpile stage of life, because some who are near to retirement have goals to preserve capital. At this point, diversification can be a great help in protecting your savings.
- Generating returns – there will be times when some investments don’t always perform as you expect them to be and through diversification, you will not then solely rely on one source of income.
Diversification In Stocks, Bonds and Cash Assets:
There are three main general asset classes in an investment portfolio such as:
- Stocks – it is a form of diversification of which an investment is allowed to own a share of a company. But while stocks offer high long-term gains, they can be volatile especially when the economy goes down. Sometimes things get to slow down a bit.
- Bonds– this is a diversification that pays interest to you when you lend your money to a company or to the government. While bonds can generate income with fair returns, they are usually weaker when the economy becomes strong.
Stocks outnumber bonds if the economy is on a steady growth, but on an economic downturn, bonds perform better than stocks. Thus if you hold on to both bonds and stocks, then you lessen the chances of your portfolio in taking a big blow when markets fluctuate one way to the next.
- Cash – it is the money in your savings account, in your MK purse or the ones hidden in between your clothes in the closet. Cash provides the lowest risk in diversification and of course gives the lowest return.
There are other kinds of assets that you must consider investing in such as properties, commodities (or precious metals like gold and silver) and other alternative investments. They are also effective to help in diversification.
Advantages of Diversification:
- Makes your Portfolio Better Shock-Proof
One major advantage of diversification is that your portfolio can better absorb the shock when the economy goes down. Since investments in different assets, the risk therefore is spread out.
- Weather Market Cycles
In every economy there is always a cycle, the market goes up, then becomes immobile, it plummets down and swings up again. With diversification, you can better weather market cycles and gain from a buoyant run.
- Enhance risk-adjusted returns
Another significant advantage of diversification is when two investments yield the same return, a diversified one will take the lesser risk than the concentrated type. The latter will be more strained than the first or former.
- Leverage growth opportunities present in other sectors
When you invest across various assets in different sectors, you can leverage or use to its advantage the growth opportunity present in them. Take for example now that we are under the pandemic, pharmaceuticals perform spectacular returns and if you invest in those companies, you will make quite significant gains. Markets see a cycle when one sector advances than the other, and this is also one of the advantages of diversification.
- Provides Stability and Peace of Mind
Another major advantage of diversification is that it gives your investment the much-needed stability and peace of mind for it can better tackle a downturn. With a more foreseeable growth and returns, it leaves off the emotional outcome from your investment which is basic for the achievement of your desired goal.
There are times when diversification means you don’t face any losses at all, because it may still be possible to lose some of your money when you invest. But the bottomline is that, through diversification, it helps you lower the risk of losses in the market at a minimum. Have you ever heard the adage: “Don’t put your eggs in one basket” before? That primarily is diversification in investing. It will always be a basic feature of portfolio construction and wealth management.
As a conclusion, it is important to diversify investments because if you put all your money in one company, it may go scarce and can lead to bankruptcy and by then, you can lose all your money. Choosing the right mix (of investment) and rebalancing or monitoring your choices can make a great difference in your outcome.
About the Author
Joseph Hogue is a financial expert and investment analyst. After serving in the Marine Corps, he started his career investing in real estate before becoming an investment analyst for some of the largest private investors. He's appeared on Bloomberg and on CNBC as an investment expert and has published ten books in personal finance. Now he helps investors reach their financial goals and invest in the stock market with some of the same advice he used when working for the rich.