One of the most important aspects of investing is diversification yet many people especially those that are investing for the first time neglect the importance of a diversified portfolio. A diversified portfolio lowers the risk of losses substantially. In other words, the saying: “don’t put all your eggs in one basket” also applies to investing.
But what is really diversification? There are many ways to diversify an investing portfolio like buying different assets classes and choosing stocks from companies that operate in totally difference sectors. A well diversified portfolio can include stocks from small companies, big companies, government bonds, mutual funds and other securities like preferred shares.
An example of the importance of putting this concept to practice can be traced back to the financial crisis. People whose portfolio consisted mostly of stocks from banks saw those assets get wiped out at lightning speed. Imagine what would of happened if all your retirement funds where invested in Fannie Mae during the financial meltdown. All your money would have literarily disappeared in a few months. But if you owned Fannie Mae at the time but you had a diversified portfolio, depending on how assets were allocated, other investments would have kept delivering profits while Fannie Mae disappeared. As of today your net worth may have even grown as long as your other investments remained profitable.
A lot of professional investors are known to rebalance their portfolios if they notice that one stock is growing too fast compared to others or if stocks grow too fast so that the percentage of capital invested in stocks goes higher than what their ideal allocation would look like they sell shares and buy other assets. The point is that diversification lowers risk and at the end delivers more profits. Famous investor Benjamin Graham believed that putting all you money in one stock is not investing but basically gambling. One good diversification strategy that some investors use is to buy shares of a mutual fund that follows the S&P or the Dow Jones in addition to personally chosen assets.
Remember that diversifying involves sectors and sometimes even investments in foreign companies. When it comes to sectors there are many, some examples are: telecommunications, finances, retail, restaurants, services, software, food and drinks. The philosophy behind choosing assets that are spread through various sectors is to avoid portfolio losses if one industry runs into trouble. The same goes for investing in foreign companies.
A diversified portfolio also invests in bonds that include company bonds and government bonds. Government bonds from the U.S. are tax free and are considered the safest investment in terms of risk but it is also one of the lowest yielding in many cases. Still, for people near retirement it is a good idea to have more money in bonds than in stocks. A bond portfolio can be diversified by investing in corporate bonds and perhaps preferred shares from stable companies. Preferred shares tend to be less volatile but are favorites among retirees and are like a mix between a bond and stocks.
In conclusion, a diversified portfolio protects your wealth and reduces the risk associated with a poor performing stock. It also helps protect against other calamities such as industry or sector recessions.
Image credit: renjith krishnan.