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Portfolio diversification - why it is so important


marcin
By Marcin Pasenik
1/31/2019
Portfolio diversification - why it is so important

When running any kind of singular investment portfolio, you might notice just how risky it is. Having all of your eggs in the one basket is rarely a good idea, and that’s especially true when it comes to your investment portfolio. If you are looking to improve your chances of success when it comes to managing your investments, it’s highly recommended that you take a look at diversifying the investment portfolio itself.

Why does this matter?

Put simply, you need to ensure that you have your risk limited. Nobody should have all of their investments placed into the one industry or market. If you do that, you leave yourself entirely open to the whims of that industry. All it takes is one major news story to break, and your presently profitable investment portfolio could soon become a nightmare!

Diversification, then, is the technique used when you need to actively reduce risk. You do this by expanding your investments into other financial platforms and industries. By doing this you make sure that you are never going to be the victim of one particular change. This is a common problem within the industry, and will likely play a key role in how you develop your portfolio in the first place.

By putting all of your portfolio into various different projects and industries, you make it much easier to ensure that it takes more than one single news story to ruin your portfolio and your profits.

So, does diversification protect me from losses?

While there is never a guarantee of protection and prevention, it’s common sense that it does offer less chance of problems. If you are using your portfolio to spread across a few different industries, you are less likely to see crippling loss. Sure, you could have problems when it comes to diversification in that you might make a poor investment due to lack of market knowledge.

However, since you are only investing a fraction of your full portfolio this is likely to be a benefit to you. You won’t lose as much if it goes wrong, ensuring that you have next to no problems in making more calculated assessments. When all of your portfolio is made up of one topic or industry, then you might feel uncomfortable taking any kind of risk. This helps you to get around that problem, and ensure you are free from such frustrations.

You can also become more of a diverse investor simply by going into different regions. If you are no longer just camped in the one industry, you will learn more about the wider world of investment. This offers the net benefit of seeing your business grow over time, and also helping you to make more expansive moves. Becoming a master of one industry or area might seem like a good idea, but expanding into numerous industries makes it much more likely that you can come out the other side with a greater knowledge of investment overall.

What kind of risk does diversification pose?

Most of the time, you will find that you are likely to come into a risk that is known as a ‘Diversifiable’ risk – sometimes instead known as a ‘unsystematic risk.’

This is specifically to the industry or area that you are investing within. It means that the particular area that you have targeted is going to be affected by its own unique set of circumstances. Instead of one major news story rocking your whole portfolio, it means that every investment comes with its own risks and rewards.

The downside is that you need to be ready to take into account a much wider variety of potential problems and issues which could go wrong. That being said, it means that you would need a catastrophic level of bad luck to see all of your investments hit with negative impacts all at once. With everything invested into the one location, though, you are much more likely to see a negative impact take place.

For that reason, then, you can hopefully see that while there is more knowledge needed to diversify your portfolio, it’s worth it. Knowing that you can limit the damage of a poor investment from spreading through your whole investment portfolio is very useful, after all.

Why diversification is the right action for you?

If you are still unsure as to why you should look to make more diverse decisions about your portfolio, consider the following:

  • For example, let’s say that all of your investments were within the auto industry. All it would take is for another emissions scandal to take place, and you would soon find that your whole portfolio would likely take a hit. It only takes one piece of bad news to damage everything.

  • However, let’s say that instead you decided to invest in 50% auto industry and 50% into the aviation industry. They are similar in some aspects, meaning that you can hopefully get your head around both industries. It would take two scandals to rock you, though.

  • While diversification is useful, though, it pays to try and stay roughly within the same ballpark as your major investment purely so you can better understand what is going on. Investing in, say, real estate and then biofuels would be two totally different industries.

  • This might make it tough to get your head around the industry, but with diversification you can move to a similar but not identical industry without much issue. This allows you to use your knowledge to make an informed decision without taking such a risk.

  • As time goes on, though, it would make sense to diversify even further into totally differing industries. At first, it pays to move into similar industries before avoiding entirely the risk of market correlation. As time goes on, though, moving further afield makes sense.

  • Lastly, you should look to diversify the kind of investments you make, not just the industry. For example, you could move from investing in stocks and instead moving into equity markets or bonds.

The challenge with diversification is making sure you move slowly enough to stay in control. Staying in the one place or too long, though, leaves you at massive risk of simply seeing the industry take a hit and punish you heavily.

Diversification, then, is a risk: but no more of a risk than leaving all of your eggs in the one basket


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