Diversification is a technique that allocates your investments in various financial instrument industries and reduces risks. Simply put, diversification combines a variety of investments which are less likely to move in the same direction at the same time.
The main objective of diversification is to ensure that you get maximum returns by investing in different areas. However, you need to understand the concept of diversification before acting on it.
You need to understand that not all of your investments will perform well at the same time. Some may do well today and some only in the future. So, if you have a variety of investments in your portfolio, it is very likely that you will have something that is performing relatively well.
What should your portfolio include?
To have a diverse portfolio, you need to include the four basic components;
Stocks are one of the most volatile investments but are known to provide an opportunity for higher growth in the long-term. Your investment in stocks could be worthless if and when you decide to sell it.
Bonds are less volatile than stocks and provide regular interest income. Most bonds even act as a cushion against the market volatility as they behave differently than stocks. It is ideal for investors who are focussed on safety than growth. However, most bonds offer lower long-term returns. Some fixed-income investments like international bonds can offer higher returns but with more risk.
These include conservative investments such as money market funds that offer stability and easy access to your money. It is ideal for people looking to preserve their principal. However, money market funds usually offer lower returns than bonds.
International stocks perform differently. So, if you are looking for investments that offer higher potential returns and risks, you may consider including foreign stocks to your portfolio.
How does diversification help?
There is no denying that diversifying your portfolio will minimize the risk. However, you need to apply strategically as it can lower your portfolio’s return below what it should be.You must make sure to include more asset classes in your portfolio to reap the benefits of diversification. The more uncorrelated the funds are to each other in performance the better it is. That way, when some asset classes are experiencing a downturn others may experience a stronger performance.
You may also look for investment opportunities beyond your own country. Remember, volatility in one country does not affect stocks and bonds in another country. So, by investing in some other country may help you offset the risks of investing in your own country.
Time is yet another factor that you need to consider while diversifying your portfolio. To pursue your goals you will have to consider two important things- your time horizon and risk tolerance.
For instance, if you are thinking of saving for your retirement that is 20 years away, you can afford to take some risks. You can think of investing in international stocks as well. However, despite having a fairly long time horizon, you should take on a level of risk with which you’re comfortable. Also, regardless of your time horizon and risk tolerance, you should consider including a fixed income component in your portfolio to help reduce the overall volatility.
Diversification helps you manage risk and reduce the volatility of an asset. However, despite having a diverse portfolio, you must remember that the risk associated with the assets can never be eliminated. The key is to find a balance between risks and returns. This will also ensure that you will be able to achieve your financial goal without losing your sleep!