Competent and flexible capital management is the basis of financial well-being. If you distribute your savings across different instruments, your risks will be significantly reduced. This approach is called investment diversification. The more diverse the assets you choose, the better your capital will feel in the long run.
What is a diversified portfolio
It can be compared to a balanced and nutritious diet. To stay healthy and strong, a person needs proteins, fats, carbohydrates, fiber, vitamins and minerals. There are no universal products containing everything at once in nature. Therefore, you need to eat in a variety of ways. The more wholesome food in your diet, the better you will feel.
So it is with investments. For a long-term strategy, it is important to distribute finance across different asset classes (stocks, bonds, commodities, currencies). Moreover, it is possible to diversify risks within each group – for example, make investments in domestic and foreign securities, keep money in several different currencies, in precious metals, and so on.
Do not think that asset allocation is a panacea for all ills and a 100% guarantee of financial success. Even the best diet will not protect you from illness and injury. Having a diversified portfolio does not mean that your assets are not threatened with a sharp drop in value. However, the strategy of “not keeping all the money in one wallet” will help to significantly reduce losses.
The modern investor has the widest range of options for capital investment. In addition to securities, there are foreign exchange and commodity markets, as well as real estate, gold, promising startups and much more. Even within the same investment class (for example, stocks), you can invest in different industries, regions and companies. The more different categories you have in your portfolio, the more robust it is in terms of value. If some of your assets fall seriously within a year, others may continue to rise, protecting you from losses.
Why diversification is so important
You have decided to invest 100% of your savings in stocks: you have chosen stocks with the highest return over the past year. However, the next year, growth gives way to recession, and your face value declined by 15%. You have nothing to compensate for these losses, since there are no reserve deposits.
In the same year, there was a boom in the precious metals market – gold and platinum rose in price by 20%. You curse yourself for being short-sighted and ask the same question: why didn’t I put some of my money into bullion or at least an impersonal metal account?
A similar situation can occur in the real estate market or in the economy of the country in whose currency you keep your savings. If you were to spread your investments across different types of assets, your investments would have a much better chance of overall growth. In other words, diversification is the only way to manage risk in the face of unpredictable financial markets.
Is there an easier way?
If you do not want to waste time on self-management of assets, there is an alternative option – mutual funds and exchange-traded funds. These are ready-made packages of securities and other assets, which are managed by experts. In fact, these are carefully designed investment baskets, where there is nothing superfluous.
Diversification is inherent in mutual funds and ETFs by default – all the ingredients of the “grocery bundles” of each fund are in the right proportions and quantities. You can invest money in several such structures at once by comparing their composition, current and potential profitability. Keep in mind that management companies charge an annual fee for their services, which should be immediately deducted from the percentage of the estimated profit.
Another option for those who have doubts about their own investor skills is to use the help of professional advisors who will prepare investment ideas for securities for you and help you build a portfolio.
Does diversification have disadvantages?
Nothing is perfect in the world. The risk sharing strategy also has drawbacks. It will be challenging for beginners to study the various asset classes to understand their nuances, strengths and weaknesses. Risk assessment can be even more difficult. Professional help in these matters can be useful, but it requires money that newbies are not always willing to spend. In addition, even experienced analysts cannot predict your investment future with 100% accuracy.
Diversification is the most effective and affordable way for everyone to reduce potential losses. Those who neglect asset allocation are much more likely to not only become disillusioned with investing, but also lose money.
