Diversification is the practice of spreading your investments and assets around to limit exposure in the event of a market downturn. This helps reduce the volatility of your portfolio over time, which is crucial to balancing the risk to reward ratio within your portfolio, and ensuring your money compounds in the long run. When we say volatility, we’re referring to the concept behind the range of price change of securities (a tradable financial asset e.g stocks) over any given period, which is the widespread measure of risk. When a stock price remains relatively stable, the security has low volatility. Low volatility typically equates to a rising market—which means less risk and more reward.
Allocating your investments across various financial industries, instruments, and other categories provides you with two strategic moves:
General market risks will affect every single one of your investments. For example, if your portfolio only contains oil stocks and those stocks see a significant decline or any bad news that will affect the immediate income of the industry, the value of your portfolio will also significantly drop.
When this happens, your entire investment could take a hit.
Now, if your portfolio is diversified, this type of risk becomes minimized. Of course, it does not guarantee against total loss. However, if your stocks drop and your target percentage gets thrown off, you’ll be able to sell off your better-performing investments and assets and use that money to buy more shares elsewhere to restore your original portfolio value.
Therefore, diversifying your portfolio can help you reach your long-term financial goals simply because it aids in mitigating inevitable risks.
A well-diversified portfolio will have investments that include a mix of:
Take Wealthfront’s strategy, for example. Using the Modern Portfolio Theory (MPT), the company has created investment software that follows a set of rules-based investment strategies to diversify investments across relatively uncorrelated assets to mitigate risk.
The goal is to achieve optimal levels of diversified investments to maintain a high return, without going overboard. In other words, a well-diversified portfolio will have somewhere between 15-20 stocks spread across a variety of industries and markets.
There are three key elements involved in diversifying your investments:
Investing in the stock market comes with varying degrees of uncertainty. If you can successfully diversify investments, you’ll be able to maintain a balance that likely yields future gains—rather than losses!Disclaimer: This content is intended for informational purposes. Before making any investment, you should do your own analysis.