Diversify much? Here’s why you should.
Diversification is an important tool every investor should know about.
If you’re an investor starting to learn the basics of how the market works, diversification can help you approach the market in a safe way that doesn’t cost you all your money.
According to Claudia Eifert, Chief Marketing Officer of Utopian Global, Diversification is an “important investor’s tool to protect your assets from the ups and downs of the financial world”
It’s based on a simple principle that can be summed up by this quote — Don’t put all of your eggs in one basket.
What does that mean?
It means you shouldn’t invest all of your money in any one asset but instead, invest in multiple asset classes. That means, splitting your money into stocks, bonds, ETFs and Index funds etc
Before diversifying, it’s important to figure out your appetite for risk.
If you’re a risk averse investor (risk averse means you’re hesitant to take on risk), you’d be more comfortable with a higher proportion of your funds in bonds or other low risk assets. On the flipside, risk-seeking investors would prefer more stocks in their portfolio.
The 60/40 portfolio
The 60/40 portfolio is the standard for how diversification should happen. The ratio here typically means 60% of your funds are invested in bonds and 40% are invested in stocks.
The proportion here allows you to invest in riskier assets like stocks while enjoying the safety net that bonds provide with their lower volatility.
Mutual funds and ETFs
An easy to diversify your portfolio across multiple industries and asset classes are mutual funds and exchange-traded funds. These investments will spread your many across many companies and assets. For example, a single share of the S&P 500 index can provide you with exposure to 500 major companies across the world, differing in size, industry and products.
It’s important to understand how each component of your portfolio operates in terms of volatility and returns. Try to re-evaluate your holdings each month if possible and…
Rebalance your portfolio
Rebalancing your portfolio is an important aspect of diversification.
If your investment in any one sector gets too large because of capital gains or disappears during a bear cycle, rebalancing can help adjust your portfolio to prevent you from leaning too heavily on any one asset.
Here’s an example of how diversification works
Let’s look at a stock and bond separately
The stock offers 10% return at 15% volatility. The bond offers 5% return at 7% volatility. As an investor, you may find each option on opposite sides of the spectrum. The stock offers premium returns but is too risky. The bond is safe but offers insufficient returns.
Now let’s mix these stocks in 60/40 proportions. When we take the average of both stocks, we get a portfolio return of 8% and a portfolio volatility of 11.8%. Notice how the portfolio offers a return higher than the bond but a lower volatility than the stock? That’s where the benefit of diversification lies.
In conclusion, remember to always diversify
Diversification in today’s world is not just valuable but crucial. Markets can be volatile enough for an investor to lose all his money in just one investment.
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