The word diversification is thrown around a lot when discussing investment, and, in this article, we’ll take a look at what diversification is, why it’s so important, and several strategies for diversifying your investments.
The root word in diversification is diverse, referring to distinctly different things, unalike and different.
The above definition applied to the way you should think of your investments means spreading your risk into various investment opportunities from safe and lower returns to those with higher risk and returns.
Simply put, do not put all of your investment money into any one entity. Instead, spread your money around into several different types of investments.
Never forget all investing is a gamble. Most investment professionals agree, while diversification does not guarantee against loss, it does minimize risk.
However, certain low-risk investments have government backing and are as close as one can get to a sure bet. But even these can have diminishing returns if interest rates change.
Simply put, diversification is a method for reducing your risk of loss. According to Investopedia, he aims to maximize returns by investing in different areas that each will react differently to the same event.
The total amount of your investment in all areas is known as your portfolio.
The whole idea behind diversification is to spread your money around into different areas so that if one particular area fails, you won’t lose all of your money, and you may succeed in other areas. Things can cycle in the market, and though you may see investments in one area go down, with a properly diversified portfolio, you can safeguard against all your assets diminishing because of market cycles, according to US News.
By investing in diverse opportunities, there are more opportunities for success.
Diversification reduces volatility, that is, fluctuations. When prices fluctuate rapidly between highs and lows, this is called high volatility.
The first of the two main types of investment risk is market risk. This includes changes in inflation rates, exchange rates, interest rates, political instability, and war. It’s also called systematic risk, as it is nonspecific to any company or industry, applies to all investors, and diversification will not eliminate or reduce this type of risk.
The second type of investment risk is a diversifiable or unsystematic risk. Investors can reduce exposure through diversification because this type of risk is specific to an economy, country, industry, market, or company. Investors look for opportunities that will not be affected the same way as those affected by market events.
How much money you invest in lower-risk opportunities versus higher-risk opportunities will depend on several factors, including your age, income, health, family size and obligations, working years left (how long until you retire), your retirement goals, your financial needs, and how much you have to invest.
For some people, mostly or only low-risk investments make the most sense. This is especially true if you are older and close to retiring or have little money to gamble with.
On the other hand, younger investors with many more work years ahead of them have a chance to earn back the money from any losses and, thus, can take on a larger share of higher-risk investments.
As a general rule, for dividing up your total investment portfolio, according to Forbes:
· For a conservative risk profile, allocate 80% of your portfolio to bonds and 20% to stocks.
· For a moderate risk profile, allocate 50% of your portfolio to bonds and 50% to stocks.
· For an aggressive risk profile, allocate 80% to stocks and 20% to bonds.
Again, consider all of the factors listed in the opening paragraph above and more before deciding that one of these simple rules is right for you. Everyone’s financial picture and needs are different and need to be adjusted accordingly.