Money managers and investment professionals often advise their clients to spread their money across different types of investments. This technique is called diversification in the world of finance. It can help protect investors against losses, and helps them maximize financial returns.
Whether you already have investments in the stock market or are just starting, practicing diversification is a great way to reach your long-term financial goals while minimizing risks. In this article, we’ll dig deeper and discuss the definition and benefits of diversification and how you can diversify your portfolio.
Diversification is an investment strategy that aims to manage and reduce risks that may come up due to market volatility. This technique involves spreading your money through ownership of different types of investment vehicles and assets. That means it doesn’t focus on the number of investments you have but on the variety.
Let’s look at how street vendors operate. You might notice how some of them tend to sell seemingly unrelated products like umbrellas and sunglasses. It may seem strange at first, especially since no one would buy those two at the same time. But by diversifying their product line and selling those two different items, they can mitigate the risk of losing money on any given day.
They can easily sell the umbrella when it rains and the sunglasses when it’s sunny. They are making money no matter what the weather is. That’s how diversification works. Like these vendors, investors have several different types of investments that carry their advantages and disadvantages. In a diversified portfolio, the investments are all affected by different market conditions - some may rise at the same time that others fall.
Let’s say you’ve recently joined Coinbase or Robinhood and started betting big on cryptocurrency. Although investing in this digital asset may give you a massive financial gain, there are times when it faces enormous market swings and crashes. Take a look at bitcoin, for example. The cryptocurrency has faced dramatic ups and downs - even in a short 6-month span between January and June 2021 it had reached highs of over $63,000 and lows under $30,000!
If you only invested in cryptocurrencies and their prices suddenly drop, your portfolio will also experience a significant decline in value. But if you diversify and, say, invest in real estate, only a part of your investment portfolio will be affected. You might even see the rest of your portfolio growing or at least not decline as much since the real estate sector continues to prove how resilient it can be despite market crashes and pandemics. With diversification, you can balance your risk and returns.
Although diversification can turn your investment returns into a smoother ride and expose you to more return opportunities, it doesn’t ensure any gains or losses. But by diversifying your investment portfolio with different asset classes, you can protect it against the volatility or sensitivity of certain market swings, ultimately lowering your risk.
Interested in looking for other investments? Read ”The 5 Best Investments to Make in 2021” to learn more.