As the old saying goes, don’t put all your eggs in one basket. Why not? Well, it’s all about managing risk. And no matter whether you’re gathering eggs or trying to build a nest egg, the same principle applies.
Just as a diversity of baskets helps the egg farmer guard against expensive loss, diversifying your financial investments across a broad range of holdings helps protect your portfolio.
Like it or not, investment growth is almost never linear. Concentrating on too few industries in the stock market means you’re likely to experience a rough and bumpy roller coaster ride, with dizzying highs and disturbing lows. A concentrated investment strategy leaves you over-exposed to the impact of external events beyond your control. Your wealth could be wiped out in a hurry, erasing years of savings and effort.
Diversification means spreading your investments not just across different sectors, but also multiple types of asset classes, company sizes, even geographic regions. The forces that drive markets up and down will never go away, but you can spread your exposure around enough to minimize the impact of any one area or industry that suffers loss and disruption.
Diversification can apply to more than just ‘traditional’ investments such as stocks and bonds. Individual investors can diversify their holdings by purchasing such things as real estate or luxury items, including fine art and precious metals.
Here’s what you’ll gain from building a diversified investment portfolio:
Reduced risk
Stocks and bonds tend to move in opposite directions when impacted by market swings, with one rising as the other falls. By spreading your investments between both, you’re better insulated against loss – even if one goes down, you’ll see gains from the other.
Diversifying the types of stocks you hold provides another buffer. If you invest exclusively in oil and that market crashes, you’ll lose big. However, if you hold both oil stocks and renewable energy stocks, you’re more likely to offset losses in one area with gains in another.
It’s better still, of course, to spread your equity investments around more widely so that no one sector suffers disruptions that send your portfolio into a tailspin.
Steadier returns
If you’re counting on your investments to generate returns, diversifying helps make sure that keeps happening. Individual investments will have down years, obviously, but that’s less of an issue for an investor who can benefit from having multiple sources of income in his or her portfolio.
Capital preservation
If you’re getting close to retirement, or you’re already retired, you’re at a stage of life where preserving your capital is more important than achieving growth. A diversified portfolio is ideal for preserving capital because you’re less likely to experience the negative effects of market volatility.
A more hassle-free approach to investing
It’s not always easy to set up a diversified investment portfolio – it takes time and effort to find the right mix to suit your taste and risk tolerance. Getting there is complicated, but worth the work – you’ll wind up with a portfolio that’s more low maintenance than most. You can’t quite set it and forget it, of course – some fine tuning and attention to detail is still required from time to time. What you’re likely to find, however, is peace of mind. By minimizing the emotional highs and lows of investing, it’s easier to make the kinds of smart, sound decisions that lead to a more stable and successful experience.
