Why Diversify? The Benefits of a Varied Investment Portfolio
Every investor has a number of critical decisions to make on entering the financial markets.
Firstly, they need to decide how they want to invest. Independently, through their bank or with the help of a personal financial advisor?
How much do they want to invest? Are they intending to put hundreds of thousands into the real estate market, or place as little as a thousand dollars with an online broker?
Are they looking to make a long term investment, or a quick turnaround, and are they after low risk, moderate returns, or do they prefer a higher risk, higher return proposition?
All these questions and more need answering before investors take the leap into the global markets. Yet, possibly the most essential issue that each investor has to consider is how they want to manage their exposure and build a strong, healthy portfolio. This is generally achieved through diversification. But, what do financial experts mean when they talk about portfolio diversification and why is it so important?
What constitutes a diverse investment portfolio is variety. Put simply, investing in a range of different trading products is the best way to spread your risk across multiple markets and ensure all your eggs are not kept in a single basket.
There are all types of financial products, such as currency pairs; bonds and stocks; ETFs, commodities like gold, oil and wheat; indices such as the DAX and the Nasdaq; and cryptocurrencies, such as Bitcoin, Litecoin, and Etherium. Investors can then also choose to trade a selection of assets within each of these categories. For instance, an investor trading in stocks can split their investments between tech stocks like Apple or Google, and energy stocks like Gazprom or General Electric.
So, what are the primary advantages of portfolio diversification? First and foremost, the main benefit is risk reduction. When you expand your basket of assets to cover a broad array of market sectors, if one market plummets, the damage to your portfolio will be negligible. Although clearly, there is no protection against overall market sluggishness, your portfolio will be more robust in the long term, as it cannot be badly bruised by a sudden shift in the value of a specific asset.
Another reason to give careful consideration to settling your investments across a wide array of markets is that by nature, a diverse portfolio is innately more stable. It enables you to explore a variety of investment types, some with a higher risk to return ratio and others that are more reliable, long term and less volatile offering a more moderate, yet more dependable return. This protects you from localized market surprises, while still allowing you to earn from potentially highly lucrative opportunities when they arise.
However, even if you are protected from critical financial exposure by spreading your assets across a number of markets, you must also be aware of the fact that diversification means that if the market as a whole enters a slump, then the value of your portfolio will, inevitably, also see a decline.
An argument exists that spreading your investments too thin can have certain pitfalls. While you won’t experience huge losses, an investment strategy that is too diversified can mean that you you can also never make a substantial profit from a market event impacting a single financial sector. Obviously, if only 5 percent of your portfolio is invested in a given asset, which then surges in value, then your profits will be equally marginal, compared to a scenario where 50% of your funds are invested. The trade-off is clear - the more narrow your investment focus the greater the risk, but also the greater the returns, and vice versa.