Diversification: What It Is and Why It’s Important
Investing one’s hard-earned money can be an essential part of building wealth. However, nothing is guaranteed in the financial world, and investors should consider following a strategy that favors consistent returns while also minimizing risk. One common method that many investors use to do this is called diversification. Essentially, this refers to not putting all your eggs in one basket (or investments in one asset class). In this post, we’ll explore why it’s important to consider diversifying one’s investments.
- Mitigate Risk
When investing, it is critical to reduce risk whenever possible. One way this can generally be achieved is through diversification. Diversifying your portfolio can potentially allow you to lower the chance that one investment jeopardizes your entire portfolio. For example, you might choose to invest in stocks, bonds, real estate, and other assets. By diversifying your investments, you can spread the risk across different asset types so a loss in one doesn’t carry as much of an impact on the entire portfolio.
- Increase the Chance for Higher Returns
Diversifying one’s investments can also provide an opportunity for higher returns within a reasonable level of risk. It is common knowledge that risk and returns are positively correlated. By diversifying your portfolio, you can invest in different assets with different risk levels, and the resulting overall return may be relatively high. For example, you might invest in stocks, which have a higher risk but potentially higher returns, and also bonds, which have a lower risk but lower returns.
- Protect Against Market Volatility
The financial markets can be volatile, and one of the best ways to protect yourself can be to diversify your investments. In essence, diversification spreads your investments across different markets and sectors, helping to lessen the impact of a market decline or crash. For instance, if you only own stock in a single company whose price suddenly falls, your entire investment may be lost. Diversification can help insulate you from such losses.
- Achieve Long-Term Goals
One reason why people often invest is to try and achieve certain financial goals. If one of those goals is to build up enough savings for a comfortable retirement, for example, diversifying your investment portfolio may help you do this. This strategy may enable you to maintain a long-term outlook while also taking advantage of varying investment opportunities.
- Gain Better Control Over Your Finances
How can diversification potentially help you maintain more control over your finances? Since the risk is now spread across different assets in your portfolio, there is less worry that a single financial event will jeopardize your finances – giving you a better sense of control. In other words, your portfolio’s overall return will be less apt to move dramatically according to the whims of external news and events that are outside your control.
There’s a reason why you hear the word diversification thrown around so much. It’s a well-proven investing strategy that can potentially allow you to better mitigate risk, achieve long-term goals, protect your finances from volatility, and maintain more control over your finances. Carried out correctly, diversification can provide an opportunity for consistent returns while potentially lessening the downside risk. Many investors have become successful by diversifying their investments, and there’s a chance you might also similarly benefit. It's never too late to consider diversifying your investments and taking more control of your finances.
* Asset allocation won’t guarantee a profit or ensure against a loss but may help reduce risk and volatility in your portfolio. Diversification cannot eliminate the risk of investment.