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Investing, without a doubt, is the best way to maintain and grow long-term wealth. Yet, the world of investing may seem overwhelming and daunting to newcomers with all of the different types of investments, assets, and terminology involved. However, a crucial principle for all newcomers to understand before delving deep into the world of investment is investment diversification. But what is investment diversification and why is it so important? What does investment diversification look like? In this blog, we hope to arm you with the fundamental knowledge of what investment diversification is, why investment diversification is so important, and what investment diversification may mean for you.
What is Diversification and What does it Look Like?
Diversification, within the realms of investing, means investing in a wide range of markets and assets to help reduce losses and risks and maximize returns. In other words, diversification means diversifying your money in a variety of investments. The general rule of return (how much money you make back on investment) is “high risk = high reward”. Meaning the riskier something is, the more potential money you can make. While it may seem tempting to put a lot of money down on risky investments to hope for a big cash out, it is often met with much loss and regret.
That is why diversification is so important. Diversification, instead of “putting all your eggs in one basket”, is branching out and placing your money in different areas. This could mean putting your money in stocks, bonds, CDs, mutual funds, and even in different sectors such as healthcare, automotive, tech, etc; Diversification is diversifying where your money goes.
Why Is It So Important
Diversification reduces the amount of potential loss that can happen from your investments. Diversifying assets can protect you from very volatile markets that would otherwise leave you in financial ruin had you invested all your money. To help better understand the importance of diversification, let us explore a fictional scenario:
John and Jessie both have $10,000 to put down in investments. John put 100% of his money in the automotive sector and into one stock hoping for easy, fast money. Jessie, unlike John, decides to only invest 10% of his $10,000 ($1,000) into the automotive sector and decides to invest the rest across different assets.
All of sudden, the automotive sector in the stock market takes a huge hit and every stock in the automotive sector is down. John lost $10,000 while Jessie only lost $1,000. Who took a bigger hit financially, John or Jessie? John took the bigger hit financially since he did not diversify his money. Diversifying may actually save you from very volatile and risky markets.
Different Types of Diversification
There is no “one way to diversify”, however, you should know about asset diversification, sector diversification, and geographic diversification. Asset diversification simply refers to having different types of assets in your portfolio, like stocks, bonds, CDs, mutual funds, etc. For example, let’s say James had entirely made up his investment portfolio with just stocks within one sector. James’ portfolio is very dependent on the state of the stock market. If the stock market were to crash then James would lose a lot of money since he put a lot of money in stock assets.
Additionally, it is important to take into account sector diversification; sector diversification is investing in different sectors like healthcare, automotive, tech, energy, etc. For instance, if James only invests in a single sector, then James’ potential return is completely dependent on that one sector, which can be very risky. However, if James were to branch out into different sectors like energy or healthcare, then James would be at a reduced risk of losing all of his money.
Lastly, one should take into account geographic diversification, which is investing in different parts of the world, like Asia, Europe, and North America. If, for example, James were to only invest within the United States of America, then all of James’ assets would be dependent on the fact that the United States of America would not go into recession or depression. If the United States did fall into recession, then James would lose a lot of money since he put a lot of money in American markets as opposed to foreign ones. Implementing these strategies can help you better achieve your financial goals.
How Can You Build A Diverse Investment Portfolio?
To build an investment portfolio just right for you, consider your financial goals, your personal amount of “risk tolerance” (how much money you can afford to lose), and the time horizon ( do you need this money now or can you wait?). Understanding what exactly you want from your investments allows you to make better-fitting financial choices. Would you like to make money within a short time frame? Perhaps consider the stock market. Would you like something for when you retire? Perhaps consider bonds, 401ks, or Roth IRAs. Your portfolio is entirely customizable and can be adjusted to better meet your financial goals.
Regardless of what your financial goals may be, you should always make an effort to branch out to other assets and investment strategies. Consider things like bonds, CDs, stocks, mutual funds, money markets, retirement plans, etc. Understanding the pros and cons of each one can certainly help you understand how each one can help you in regard to the establishment of your financial goals. Knowledge is power. Having the knowledge to understand all different types of investments informs you as to which one is just right for you.
The Role of Portfolio Management in Investment Diversification
You should always keep a close eye on your investments to incorporate efficient investing strategies. Have your bonds matured? Do you think it is about time you start putting money in mutual funds? Constantly checking up on your investments, seeing what does and does not work for you (in terms of maturity for investments), or trying new forms of investing, is essential for accomplishing your financial goals.
Constantly balancing and adjusting your investment portfolio is a very healthy investment habit to get into since you are able to change assets according to your financial goals. For example, have the value of your stocks gone up significantly? Then you should perhaps sell before the value goes down. Investing in a multitude of sectors and assets can guarantee the establishment of your long or short-term financial goals since you will always be in constant touch with what is happening regarding the market and your assets.
Do not be afraid to try new strategies for investing. Some people only ever invest in low-risk assets and either fear or ignore the benefits of riskier assets. However, by experimenting with new investment strategies, one also naturally creates diversification within their portfolio. Investing is all about taking on some level of risk.
Investment Diversification Best Practices and Strategies
Understand the relationship between risk and return (high risk = high reward, low risk = low reward), and always have a close eye on your investments. This way you may adjust your portfolio to better fit your financial goals. Also, understand your level of “risk tolerance” (how much money you are willing to lose on each investment) in relation to each investment you make.
You may not be able to dump thousands of dollars into investments alone and that’s okay! So long as you do what you can with what you have. A good practice to get into is to become informed about the different types of investments and pick which ones can better meet your financial goals. Ideally, you should spread your money everywhere and properly gauge when you need the investments to mature. For example, if you are looking to gain money for a child’s college education, then you probably should not invest most of your money into really long maturing investments like IRAs or 401ks.
Conclusion
Diversification is putting your money in different markets and assets. Diversification is essential for achieving financial goals, reducing risk, ensuring financial stability, and developing and maintaining wealth. Remember to take into account your goals, risk tolerance, and time frame. This can help better create an investment portfolio that is right for you.
For more informational content on investing topics like these, visit our investing page!