Diversification is a necessary step in any investment portfolio.
Diversification is a broad concept that can refer to many things. For example, it may mean expanding the range of products & services produced by a company as well as developing new industries in order to increase production efficiency. In this article we will focus on the benefits of diversifying your investment portfolio.
Modern portfolio theory is a method of choice of assets, with the goal of maximizing return and minimizing risk. It was created by American economist and Nobel Prize winner Harry Markowitz. In 1952 he published an article called “Portfolio Selection,” in which he recommended distributing investment funds among several securities so as to limit losses to any one type of security.
Taking more risks will likely lead to a higher return on investment. But be warned – their values may rise sharply, or fall sharply.
Risk management is one of the main ideas that come from modern portfolio theory, and it works by combining high-risk assets with others. The risk will be lower than for individual instruments. For example, instead of only buying stocks, you can combine them with bonds.
Ideally, one should look for assets that act differently in the same conditions. For example, when oil prices go up, some securities may get more expensive but not all of them do. By spreading his investment across different securities, an investor can protect himself from volatility by shielding against loss in one security by making a profit in the other securities.
Sometimes the proportions of something change overtime; for example, initially, stocks worth 70% and bonds holding 30%, but now stocks represent 80% and bonds are only last at 2%. Keeping a portfolio rebalancing will help maintain an even risk level as time goes on. To return the portfolio to its original state, you must rebalance it. This can be done be selling some of the shares which have increased in price and investing the proceeds, or additional bonds to offset a sell off due to rising interest rates.
Pros of diversification:
- Lowering the risk is important, which can be done by diversifying over different stocks. This reduces the specific risk of investing in one company. You can reduce the level of risk even further by spreading investments over different sectors to ensure that if one falls, others will rise;
- Another great benefit is that by investing a portion of your funds into “high-risk” assets, you can still keep the other portions in lower-risk investments. Even though this does increase your overall risk level (as high risk exposure will fluctuate more), it also increases your potential gains (as upswings will mean better performance);
- Protection against a volatile market can be provided with the help of futures contracts, which stabilize the market.
What are the cons?
Diversification does not protect against systemic risks, which are prevalent in the current financial system. These risks affect all securities and could result in the collapse of the whole system. Take, for example, the case of one bank failing to fulfil its obligations and declaring a default. And then, due to that one cascade of other defaults followed;
You’ll need to spend more time managing a fund with a lot of investments, but that doesn’t mean you should automatically avoid it;
The more you invest in various stocks, the more commissions you’ll have to pay. If diversification is a goal, it’s better to limit the number of stocks that are actively growing and owning shares in the others. For example, if there are 10 stocks in your portfolio that are actively growing and the other 40 aren’t, then your average gain will be greater than if.
Diversifying your assets is important because it means bring less volatility to your investments. This way, if the economy is slow you can still make a good amount of money. Stocks, bonds, deposits, funds are some of the simplest ways to invest in stocks- if you’re looking for a way to make money while learning.
You can also transact futures contracts which allow you to lock in the price and supply of goods that’ll be needed in future months. This is more risky, and probably best for experienced investors. If you’re not sure how it works, it’s best not to get involved with them.
We also need to diversify the types of business we are exploring. This is important because it can help reduce volatility and minimize downside risk. The 2008 global financial crisis is a perfect example of why this may be necessary. Investors are always looking to balance their portfolio and end up gaining a minimum amount of profits when stocks go down. So if you have invested in 5 stocks, 1 of them might go down while another one goes up.
Because of the pandemic and closed borders, the oil/gas industry and aviation have suffered. In contrast, shares in agro-industries, petrochemicals and retail companies have increased. Had you still held this portfolio of stocks in March, it would have been completely destroyed. Besides the reduced dividend income you would also have been blocked from buying shares at a very low price since some companies in your portfolio were temporarily not paying dividends due to financial difficulties.
When choosing and benchmarking against specific companies the variety of methods available to you is endless. Some people need more financial information that others, so make sure to get in touch with what’s important for your situation. Someone else might find.
When trying to diversify your regular, allocate assets across different currencies. For example you will not be able to buy US stocks with US dollars without first buying the US dollar. A broker may offer this by having two buy order book pages side-by-side: one for trading in USD and one for trading in EUR.
However, diversifying your portfolio too much can make it difficult to manage. You don’t need to buy as many different stocks and options as possible. It’s more important to focus on a range of stocks within your skill set that will benefit you the most.
All in all, whichever strategy you pursue will surely serve you well. By investing in different and more successful stocks, you’re automatically increasing your chances of making a profit.