Traditional wisdom says don’t put all your eggs in one basket. Having “eggs” in multiple baskets mitigates risk, as if one basket breaks, not all eggs are lost.
This technique restricts the damage to your financial well-being in case one asset class or instrument goes for a tailspin.
People are accustomed to thinking about their savings in terms of goals: studies, marriage, retirement, a down payment, or a vacation. But as you build and manage your asset allocation—regardless of which goal you’re pursuing—there are two important things to consider.
The first is the number of years until you expect to need the money—also known as your time horizon.
The second is your attitude toward risk—also known as your risk tolerance. For instance, think about a goal that’s 25 years away, like retirement.
Because your time horizon is fairly long, you may be willing to take on additional risk in pursuit of long-term growth, under the assumption that you’ll usually have time to regain lost ground in the event of a short-term market decline.
One of the keys to successful investing is learning how to balance your comfort level with risk against your time horizon.
One way to balance risk and reward in your investment portfolio is to diversify your assets.
This strategy has many complex iterations, but at its root is the simple idea of spreading your portfolio across several asset classes.
It can help mitigate the risk and volatility in your portfolio, potentially reducing the number and severity of stomach-churning ups and downs.
2.0 WHAT IS DIVERSIFICATION ON INVESTMENT PORTFOLIO?
Diversification is a technique of allocating portfolio resources or capital to a mix of different. It is spreading your risk across different types of investments, the goal being to increase your odds of investment success.
Diversification is the practice of spreading your investments around so that your exposure to any one type of asset is limited. This practice is designed to help reduce the volatility of your portfolio over time.
In practical terms, diversification is holding investments which will react differently to the same market or economic event. For instance, when the economy is growing, stocks tend to outperform bonds.
But when things slow down, bonds often hang on better than stocks. By holding both stocks and bonds, you reduce the chances of your portfolio taking a big hit when markets swing one way or the other.
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.
3.0 WHY TO DIVERSIFTY YOUR INVESTMENT PORTFOLIO?
By diversifying your portfolio, you reduce the consequences of a wrong forecast. However, remember that diversification does not ensure a profit or guarantee against loss.
Let’s say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on an indefinite strike and that all flights are cancelled, share prices of airline stocks will drop.
That means your portfolio will experience a noticeable drop in value. If, however, you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected.
In fact, there is a good chance the railway stock prices would climb, as passengers turn to trains as an alternative form of transportation.
By diversifying, you’re making sure you don’t put all your eggs in one basket. You should diversify across the board, not only different types of companies but also different types of industries.
The more uncorrelated your stocks are, the better. It’s also important to diversify among different asset classes. Different assets such as bonds and stocks will not react in the same way to adverse events.
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.
3.1 Pros of Diversification
There are many benefits to diversification:
- Reduces volatility in your investment portfolio
- Minimizes the risk of loss to your overall portfolio- reduce portfolio risk
- Exposes you to more opportunities for return- offers higher returns in long-term
- Hedges against market volatility – safeguards you against adverse market cycles
3.2 Cons of Diversification
While there are many benefits to diversification, there may be some downsides as well.
- Limits gains short-term – since higher risk comes with higher rewards, you may end up limiting what you come out with.
- Time-consuming to manage- somewhat cumbersome to manage a diverse portfolio
- Incurs more transaction fees, commissions, brokerage charges, etc.- not all investment vehicles cost the same, so buying and selling may be expensive.
Diversification won’t prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.
Diversification can help an investor manage risk and reduce the volatility of an asset’s price movements.
Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.
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.
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.
Categories: MANAGE YOUR FINANCE