Finance
Council Post: Understanding The Importance Of Investment Diversification
Published
2 years agoon
By
James White
Henry Yoshida is CEO of Rocket Dollar, helping Americans unlock retirement funds with Self-Directed (S-D) IRAs and S-D Solo 401(k) plans.
Investing in a diversified portfolio will help you maximize returns while minimizing risk. But what does that mean? How do you go about investing in a way that protects your assets and gives you the best chance of making money? Is it possible to be too diversified? Let’s look at why investing in an array of asset classes is essential, starting with the basics.
Diversification is one of the critical elements of a sound investment strategy. By spreading your investments over various asset classes, you increase the likelihood that at least some of your investments will do well even when others don’t.
To understand why diversification can be beneficial, we’ll begin with an example: Imagine that you are investing in two companies—one producing organic baby food and the other making bicycles. Both businesses are doing well, so you buy shares in both companies by purchasing $10,000 worth each. However, over time things start going poorly for the baby food company; demand for organic baby food decreases but interest in biking among young people increases! The increase in biking interest helps offset the losses in the baby food company.
Diversification helps with risk management and protecting your assets. Instead of having all your money in one sector or place, spread it out to give yourself greater protection if something goes wrong.
If you look at different portfolios, you would likely see a diversification of assets. Most investors don’t have all their money in one sector or investment. Instead, they typically spread it out among a variety of investments and asset classes. Why? Because this can help reduce risk and protect their assets from harm.
The primary benefit of diversification is that it reduces the volatility of your portfolio; that is, if one investment goes down in value, another may be going up at the same time so that overall performance remains positive over time (even if just barely). For example: If you were to invest 100% of your portfolio in stocks, then when the stock market went down 10% (a pretty common occurrence), an entire year’s worth of growth would be wiped out overnight! Diversification mitigates this risk because when some assets are falling in value others tend to rise—so even though there will always be losses due to some poor choices made by investors or companies themselves (or both), when properly diversified, there will likely still be gains offsetting those losses on average across all investments equally, meaning they won’t kill our chances at prosperity altogether.
The most important thing you can do when investing is to avoid trying to time the market. Trying to get in or out at the right moment will likely hurt your returns, and it’s impossible anyway. Even professionals with access to all kinds of complex algorithms still can’t do it consistently. It can be better to focus on making sure that you have something invested when an “up” period begins than trying to guess when that might be and then scrambling about trying to buy more shares before prices start going up again. A diversified portfolio helps ensure this because even if one sector does poorly, another might be doing well enough for overall gains; if one asset class loses its value compared with others, others may have gained theirs instead; and if one company goes bankrupt (as some inevitably will), there are other companies whose stock price isn’t affected by this event.
It’s important to invest in a variety of investment vehicles so that you mitigate risk while maximizing opportunity. Diversification can help reduce risk by spreading your money around, giving less exposure to any one security or sector.
For example, if you’re invested in only stocks, and the stock market crashes, it could wipe out most or all of your portfolio value. But if you have a diversified portfolio with bonds and real estate investments as well as stocks (and maybe even some cash), then when the market drops, it may be less likely that all of those investments will lose value at the same time.
Since we can’t time the market—and there are no guarantees about what direction it’ll go—it’s wise to spread out your investments over time so that when an “up” period begins, there will be something invested while waiting for others’ growth periods—or even just a flat period—to begin again.
Conclusion
Diversification is an important concept for any investor. By diversifying your portfolio and spreading your investments across different asset classes, you can reduce the risk of losing money on a single security or market sector. You will also increase the likelihood that at least some of your investments will do well even when others don’t.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
Forbes Finance Council is an invitation-only organization for executives in successful accounting, financial planning and wealth management firms. Do I qualify?
Source: Forbes
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