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The Importance of Diversification

Diversification can be neatly summed up as, “Don’t put all your eggs in one basket.” The idea is that if one investment loses money, the other investments will make up for those losses. Diversification can’t guarantee that your investments won’t suffer if the market drops. But it can improve the chances that you won’t lose money, or that if you do, it won’t be as much as if you weren’t diversified.

Diversification is a technique that reduces risk by allocating investments among various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.


Why You Should Diversify & Spread Your Risk

If you invested all of your money into one company’s stock and it plunged, you’d lose your money. If you put all of your money into a single bond and the issuer declared bankruptcy, you’d lose your funds, too. Diversification is mitigating the risk to you about such scenarios by choosing different investments and types of investments. Diversification doesn’t guarantee profits or protect against loss, but it may help protect your portfolio.

In a diversified portfolio, the assets don’t correlate with each other. When the value of one rises the value of the other falls. It lowers overall risk because, no matter what the economy does, some asset classes will benefit. That offsets losses in the other assets. Risk is also reduced because it’s rare that the entire portfolio would be wiped out by any single event. A diversified portfolio is your best defense against a financial crisis.

And finally, don’t forget, location, location, location. Diversification also means you should look for investment opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.


Diversify Across Asset Classes

A well-diversified portfolio combines different types of investments, called asset classes, which carry different levels of risk. The three main asset classes are stocks, bonds, and cash alternatives. Many investors also add other investments, such as real estate and commodities, like gold and coal, to their portfolio.

A combination of asset classes will reduce your portfolio’s sensitivity to market swings. Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.

Stocks generally carry the most risk of the three main asset classes, but they also offer a great potential for growth. Bonds are less volatile, but their returns are more modest, and cash alternatives are generally considered to carry the least risk but can either require a lot of work like real estate or they can offer lower returns such as gold or coal. Each asset class tends to perform differently under similar market conditions.


Diversify Even Further into Subclasses

Once you’ve diversified by distributing your investment dollars among different asset classes you need to diversify again. In this case, you divide the money you’ve allocated to a particular asset class among various categories of investments that belong to that asset class. These smaller groups are called subclasses.

For example, when it comes to stocks, the possibilities for diversification are vast. You can diversify by the size of the companies (large-, medium-, or small-cap stocks), by geographical market (domestic or international), and by industry and sector, for example. The more uncorrelated your stocks are, the better.

If you want to diversify among stocks but don’t have the time or inclination to do so, consider mutual funds or exchange-traded funds. These funds generally hold shares in many different companies. There are also funds that shift their asset allocation away from equities as it approaches a certain target date. These target date funds are geared towards retirement planning where the target date approximates the retirement date of the investor.

If you want to diversify your portfolio into Real Estate subclasses there is no shortage of options. You could invest in a plethora of possibilities such as Single-Family Rental Houses, Multi-family Rental Properties (Duplexes, Triplexes, and Quads), Apartment buildings, Trailer Parks, Short Term Rentals, Vacation Rentals, Real Estate Investment Trusts (REITs), Farmland, Timberland, Hunting Land


How Many Stocks Should You Have?

Obviously, owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference.

For example, take a portfolio that contains only stocks. If the stock market drops 20%, your portfolio would lose 20% of its value. But if you were 50/50 invested in stocks and cash, your portfolio would only lose 10% of its value.

You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes. You can also keep changing your mix of investments mix over time.


The Bottom Line

You will receive the highest return for the lowest risk with a diversified portfolio. For the most diversification, include a mixture of stocks, bonds, mutual funds, fixed income, and commodities such as real estate. Diversification works because the assets don’t correlate with each other.

A diversified portfolio is your best defense against a financial crisis. Your diversification strategy should be tailored to your personal financial goals and tolerance for risk. If you’re uncertain about how to diversify, consider seeking the guidance of a Financial Advisor.

The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night’s rest.


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