We all take calculated risks in life. The trick is to minimize them so we gain the maximum rewards for minimal risk.
Around 65% of people say they’re intimidated by the stock market. Yet the same everyday principle holds true for investment strategy. Investing is a simple matter of managing risk.
Below, we’re taking a look at how to minimize risk by diversifying investments.
What is Risk?
In the financial sense, “risk” isn’t too different than the standard meaning of the word. It’s the expression of things working out for the worst. It can be a lot more subtle in finance, however.
In investment, the risk is the chance of your investment yielding below expectations. In most cases, a realized risk will result in your investment underperforming. In more dramatic cases, it might wipe out your returns altogether and might sometimes result from sweeping economic factors.
Different investments carry different kinds of risk. Property, for instance, is often subject to a country’s economic fortunes. Property also has low liquidity, so it can be hard to sell if things start to pinch.
Investment risk does have one unique wrinkle. As a general rule, higher risk investments also yield better returns. Like a game of poker, the more at stake, the more there is to lose.
Taking on risk isn’t always a bad thing. But even high-risk investors know to protect themselves from losses. That’s where diversification comes in.
What is Diversification?
You’ve probably heard of this phrase: “Don’t put all of your eggs in one basket”.
If you understand what that means, then you already understand the basic concept of diversification.
Diversifying is important in investing because it protects you from extreme financial losses by limiting the amount of risk you’re exposed to. If something goes wrong with one of your investments, you’ll have others to keep your portfolio ticking over.
If you fail to diversify, a single underperforming investment could be enough to wipe out your entire portfolio. You’ll be back to where you started with nothing to show for it. With diversification, your other investments can make up for losses experienced elsewhere.
Diversifying is important no matter how confident you are in an investment. Investments often defy predictions and yield above or below expected results. You can’t assume your investment will perform as expected.
How To Diversify Your Investments
Now you know the importance of diversifying, it’s time to start figuring out how to do it.
It doesn’t have to be complicated. At its most basic, investing in a number of different stocks can be enough to insulate you against financial shock.
For best results, you’ll want to apply a little more strategy.
Spreading your portfolio through multiple investment vehicles can protect you from the intangibles of the wider economy. Stocks, bonds, ETFs (for example) all have different growth rates and are subject to different market forces.
One sensible trick is to diversify into investments that move independent or even opposite to each other. This ensures that while one industry is experiencing a dip, another will be business as usual or on the climb.
Spreading your investments worldwide is another great way of protecting your cash. An economic crash or tense political situation can send stocks tumbling in a particular country. For an example, take a look at the uncertainty generated by Brexit, the results of which may affect investors for years to come.
How Much Diversity is Enough?
The other big question lies in how much you need to diversify. This can vary based on your own investment situation, but there some general rules of thumb to help.
Diversifying too far is a subtle trap. By itself, it does no active harm — the risk is low. But it also holds back your investment power. Think of it as a bed of nails. Spread too wide, your investment power can’t achieve significant results.
A common rule of thumb is to never go above 30 investments. Beyond that, you’ve dispersed your investment potential too far.
How you diversify may prove more important than the number of investments you have. Fewer investments diversified further will often prove more effective than many investments focused in a single industry or market.
Drawbacks of Diversifying Your Portfolio
So, you’re all set to start diversifying. But let’s slow down for a moment and take a look at its drawbacks.
Diversifying can protect you from financial miscalculations, but it can also water down your investment power. If you invest in higher yield, riskier prospects and diversify into safer investments, you may end up with below average returns overall.
Your portfolio can also become difficult to manage if you diversify too aggressively. You might struggle to keep your finger on the pulse. If you diversify without appropriate research, you’ll invest in stocks you know little about.
Transaction fees can also add up quickly when you diversify. If you aren’t smart about it, you can end up wiping out your investments with fees.
Diversifying might itself introduce elements of risk. Investing in multiple countries can protect you against economic forces, but it can also force you to engage in higher-risk markets, like those in developing countries.
It’s also worth remembering that risk isn’t a one-time thing. Markets shift and change. Your safe investments today might represent risks tomorrow. Stay informed about your investments to see where you might need to make changes.
The Importance of Diversifying Investments
It should be clear that diversifying investments is the key to ensuring you receive returns over time. Going for high-risk investments might yield fantastic returns, but you also take on more risk. You need to diversify to protect yourself should anything go wrong.
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