The first advice that most beginning investors get is to build a diversified portfolio. Yet many people don't really understand why diversification gives them an advantage. Below, we'll take a closer look at diversification and the strategies that you can use in order to build it into your portfolio.
There are two primary reasons to diversify. First, diversified portfolios have less risk than concentrated portfolios. Second, diversification allows investors to add riskier types of investments to their portfolios without increasing their overall risk levels.
It's easy to understand why diversified portfolios have less overall risk. Consider the example of a portfolio with one stock in it. If something happens to that company, then the stock will be worthless, and investors will lose all of their savings. By contrast, if a portfolio includes equally sized positions in 10 stocks and that one company once again faces a crisis that sends its stock to zero, the portfolio will only suffer a 10% loss.
Diversification also gives investors the ability to make partial investments in asset classes to which they ordinarily wouldn't feel comfortable committing 100% of their savings. For instance, many retirees seek to reduce the overall risk in their portfolios. Yet one common mistake is for such conservative investors to sell off all of their stocks. In fact, by retaining at least a modest percentage of their assets in the stock market, retirees and other conservative investors can actually reduce the risk in their portfolios and boost their returns compared to an investment portfolio composed entirely of fixed-income investments and other assets considered to be free of risk.
Ways to diversify
There are several ways you can diversify your portfolio. The most common is through the use of mutual funds and exchange-traded funds. These funds allow you to invest small amounts and have your investment pooled with those of thousands of other investors. The fund puts together all of its shareholders' savings and is able to buy dozens or even hundreds of different investments.
You can also build your own diversified portfolio by combining numbers of individual stocks, bonds, or other investments. In general, buying stocks that differ in size, industry, geography, and corporate strategy can give you more of the benefits of diversification. Focusing on similar stocks in the same sector adds minimal diversification to a portfolio.
Diversification can't protect investors entirely from risk. Sometimes, financial markets lose value at the same time, and nearly every stock, bond, or fund loses value. More often, though, a diversified portfolio will cushion the blow of a downturn and help you avoid the full consequences of making an unfortunate stock selection.
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