Why It's Important to Diversify Your Investing Portfolio
June 3, 2022
A diversified investment portfolio is the key to building wealth. Without a diversified portfolio, you could lose everything when the market takes a downturn.
Is that a risk you're willing to take?
If you're like most investors, it's not, and that's why it's important to diversify your portfolio.
What Is an Investment Portfolio
An investment portfolio is the total of all of your investments. No two portfolios are the same, and you should never have all your eggs in one basket.
There's no right or wrong way to build a portfolio. Still, the right investment strategy understands that investing involves risk and works to diversify the market risk so the portfolio doesn't fall apart in the blink of an eye.
Why Is It Important to Diversify Your Portfolio
You know you shouldn't have all your eggs in one basket, but do you know why it's important to diversify your portfolio?
Many investors just think it's the right thing to do, so they do it, but here are the real reasons your financial advisor likely advises you to use a diversification strategy.
Generate Stable Returns
Diversifying your portfolio doesn't automatically mean you'll have higher returns, but it does lower your risk.
Let's say you invested all your money in the stock market, and the stock market crashes. What happens to your investments? You pretty much lose everything, right? This is especially true if you invest all your money in one type of stock, such as technology stocks.
When you diversify your investments in different asset classes, you reduce the risk of a total loss should the market fall. For example, investing some of your portfolio in stocks and another portion in bonds might not lose everything because stocks and bonds perform differently.
The point of investing is to make money, right? So it makes sense to manage your risk when you create an investment portfolio.
Again, putting all of your capital in one investment type is risky. It's like betting all your money on one racehorse at the racetrack. There's no guarantee that your horse will win, just like there's no guarantee the company or industry you put your money in will succeed.
Putting your money in different investments reduces the risk of a total loss and increases your chance of reaching your financial goals.
Diversifying your portfolio also helps you preserve capital. When you aren't investing in all risky investments, you lower the risk of losing your entire portfolio or capital invested. When you aren't losing capital, you have a better chance of making money on different asset classes and reaching your financial goals.
Types of Assets Behave Differently
Understanding that different types of assets behave differently is the key to understanding market volatility and minimizing risk.
If you invest in different asset categories, you'll see different returns based on the market's performance. Adding individual stocks, bonds, commodities, ETFs, real estate trusts, and even physical real estate to your investment portfolios ensures that you hit all areas of the market and increase your chance of higher returns.
Work with your financial advisor to find investments that work opposite of one another so that when the stock market falls, you know you have capital preserved in other investments that might even be performing well despite the market's downfall.
Portfolio Diversification Example
Determining when a portfolio is well-diversified can be deceiving. For example, many investors assume their portfolio is diversified because they invested in a few stocks or they spread their money across multiple ETFs (exchange-traded funds), when in reality, they are investing in the same stocks just in different investments.
For example, if you invest in two index funds, each of which follows a different market, but one mimics the S&P 500, you're already investing in as many as 75% of the top US equities. If you invest in another index fund, chances are you're investing in the same stocks twice.
This doesn't diversify your investment. If the market tanks and those particular stocks do poorly, you lose in both investments rather than having an investment that offsets the loss.
Instead, it's a better idea to invest some money in the index fund, say the fund that mimics the S&P 500, and invest your other money in investment products, such as bonds, real estate, real estate investment trusts, or commodities.
Most investments react inversely to specific market pressures. If something occurs in the market that causes the stock market to crash, chances are the other investments won't react the same way, many of which may perform well and preserve your capital.
Different Types of Risk
When you measure the risk of an investment, you should consider the two types of risk - systematic and unsystematic risk.
Systematic risk or market risk and affects almost all investments and investors. It's not something investors or companies can control, and it includes things like inflationary pressures, rising interest rates, political complications, and even war.
Unsystematic risk doesn't pertain to the market as a whole. These are risks that affect a specific investment, company, or industry. For example, a company's financial risk is unsystematic. However, you can diversify your investments to get around this type of risk, which again is why it is important to diversify your portfolio.
Drawbacks of Diversification
There are drawbacks or downsides of diversification in investing, like any investment strategy. Understanding what they are and how to avoid them is important.
For starters, you could over diversify your portfolio. Spreading your money too thin can affect your profits because the expenses increase with each investment you buy and sell. You also may not have enough invested in the 'right investments' to gain enough earnings because you spread yourself so thin.
It's also a lot easier to make mistakes when you diversify your portfolio too much. Keeping track of where each investment is, how much you have invested, and how it works into your asset allocation can get confusing and time-consuming, leading to mistakes.
Finally, there could be large tax consequences for diversifying too much. Each time you sell an asset for a profit, you might incur a tax liability. If you aren't careful, you could put yourself into a higher tax bracket just by diversification in investing.
How Diversified Should Your Portfolio Be?
The 'old school' method of diversification was a 60/40 split with 60% of your capital invested in stocks and 40% in bonds.
This still rings true today, but you should consider other factors such as your timeline, intended goals, and risk tolerance. Think about how close or far you are from your intended timeline, as that will help you determine how aggressive or conservative you should be with your portfolio. The more conservative you must be, the more diversified you may want your portfolio.
How Do I Get Started Investing?
You don't need to be rich to start investing. You can start with as little as $1 on some platforms. The key is to find an investment platform you are comfortable with and that you meet the minimum investment requirements of and get started.
The sooner you start investing, the faster your money can grow. Try to have a long-term plan with your investments, rather than investing for short periods and withdrawing your funds. Coupled with diversification, you can get a good start on your investment portfolio.
How Many Stocks Should I Invest In?
There is no right or wrong number of stocks to invest in. What's right for you may not be right for the person next to you. It depends on your risk tolerance and financial goals. While most portfolios should include at least some stocks, many portfolios will be heavy in stocks while just as many will not.
Can I Lose Money With a Diversified Portfolio?
There is never a guarantee that you'll make money when you invest. No matter how diversified your portfolio is, there's always the chance of a total loss. No one can predict what the market might do or how your investments will react.
The Bottom Line
If you wonder why is it important to diversify your portfolio, it boils down to one thing - security. Without diversification, you put your portfolio at risk of a total loss. Spread your money out across a variety of investments and watch how they perform differently. Learn more by signing up and visiting our blog.
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