Why Is Diversification Important in An Investment Portfolio?
There’s a pretty good reason why we’ve always been told to “never put our eggs in one basket”. Diversification is the act of spreading our investment dollars across a range of assets to reduce investment risk. Maintaining a well-diversified portfolio helps balance volatility and even unlocks more opportunities for earning.
- How does diversification reduce risk?
- How does diversification strengthen an investor’s portfolio?
- A well-diversified investment mix: why should you diversify your investments
- Try diversifying your investments for great rates no matter the market with P2P lending
Someone has probably advised you at some point to start diversifying your investments and maybe you already get what diversification is.
But why is diversification important in an investment portfolio? After all, if a certain investment works just fine, why invest in many other different things?
Diversification is a cornerstone concept for successful investing. Just as you have the driving motivation to build wealth, so too should you think about keeping your assets protected by minimizing risk.
How does diversification reduce risk?
Diversification is an investor’s safety net– it protects you against risk. Diversifying reduces the likelihood that all your investments will lose value at once and can smooth your portfolio’s returns.
Let’s go back in time for an example.
In the 17th and 18th centuries, trade galleons from Europe would bring all sorts of stuff to and from the Americas.
But crossing the Atlantic was a risky proposition. In those days, it took weeks for a ship to make the trip either way and they could get lost, get sunk by storms, or be set upon by pirates. If the ship was lost, then so were all your profits.
Smarter merchants would, therefore, spread their inventory across several ships. On the off chance one ship sank, they still had enough to trade, make a tidy profit, and then call it a day.
While a little basic, this is essentially the reason why you should diversify your investments. If one ship sinks you have others to keep your portfolio afloat.
How does diversification strengthen an investor’s portfolio?
Besides lowering risk, diversification also helps you generate a more steady income.
Back to our shipping example. If a merchant used multiple ships but only had one route, what would happen if that route was closed down? They would still lose their whole business. A smart merchant would therefore have multiple ships running multiple routes
A well-diversified portfolio is one that performs well no matter the economic environment. If you only invest in stocks what happens when the stock market tanks?
A well-diversified investment mix: why should you diversify your investments
Let’s consider a few scenarios to further illustrate why diversification is important in an investment portfolio.
Suppose we had two investors, Walter and Jessie. Each has $10,000 to invest, but Walter decides to diversify his investments, while Jessie decides to go all in on one.
Jessie chooses to put down all $10,000 into stocks in the manufacturing industry. Walter, in the meantime, also decides to buy up manufacturing industry stock but only with $2,000 worth.
Walter also picks out four other investments: some real estate crowdfunding, a pharmaceuticals ETF, some laundry machines, and a restaurant business, spreading out his $10,000 among five different interests.
Let’s say all these different investments gain on average 10% year-on-year. Let’s have a look now at a couple of scenarios
In a good market
Suppose the economy is doing quite well, with all sectors experiencing tremendous 20% growth. The manufacturing industry, in particular, is doing incredibly well, and is up 35% that year.
Good for Jessie, who has now earned an extra $3,500, bringing his total portfolio value to $13,500. Walter also makes some gains – making $700 from his manufacturing stocks. He also makes $400 from each of his four other investments that year, bringing his total earnings to $12,300.
Both gentlemen make some significant gains, although Jessie has the edge over Walter in this case.
In a bad market
Here’s why it’s important to diversify your investments.
Now say the manufacturing industry is taking a beating in the next year, with stocks losing 30% of their value. All other sectors are also affected by the loss, suffering a 10% hit.
This means Jessie’s $13,500 invested in manufacturing also loses 30%, whittling down the value to $9,450. Walter also loses a bit of money; his $2,700 invested in manufacturing has now gone down to $1,890.
His four other investments have also gone down, though not as much as his manufacturing stock. His investments in the restaurant, the pharma ETF, laundry machines, and real estate are now at $2,160 (from $2,400 each).
Walter still has $10,350, holding on to a net gain of $350 over the past two years. Jessie, in the meantime, with $9,450 is down $550 from his initial position.
As you can see, by diversifying his investments, Walter hasn’t been as hard hit by a bad economy compared to Jessie. To reap the benefits of diversification, portfolio managers (such as Walter) should look into investing in different asset classes or asset types.
Other diversified portfolio examples
There are a lot of finance experts out there with advice for different portfolios. Check out how diversification reduces risk on investments by looking at some tips about diversifying from experts on our blog.
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