“The stock markets have crashed.”
“Interest rates on fixed deposits and savings account have fallen.”
“Gold prices have risen.”
“Real Estates market is on the upbeat.”
You must have come across with such phrases in your life.
Actually, the investment market is never stable.
That’s why there is risk involved in the investment. At any point in time, one cannot be certain and sure about the returns on our investments.
The return margins can be thin, or they may be thick. You may also face a loss of your invested sum of money.
So, how you go about guarding your invested sum of money so that you can optimize your returns on your investment.
Well, it’s about Investment Diversification.
In fact, diversification is quite a popular term with investors.
The essence of Investment Diversification can be picked from the phrase: “Never put all of your eggs in one basket.”
From an investor’s point of view, there is much to be discovered about diversification. The practical implication of investment diversification can be understood only when you know how to diversify your portfolio.
Diversification will be a reality for you when you go on to understand the importance of having a diversified portfolio.
What is Investment Diversification, why you need to diversify your portfolio and how you go about diversifying your portfolio is the center of discussion in the present post?
What is meant by Investment Diversification?
In simple terms, Diversification of Investment means that you do not put your money in only one of the investment options.
On the contrary, whatever amount of investment you do, you make it through different options available for investment.
For example, if you have 1000 Dollars for investment. You decide to put part of your money in bank account, some part of the money as a deposit, some part invest in stock market, with some you buy insurance and with other you buy bonds and securities and rest with of the fund you purchase Gold.
The above scenario presents you an example of how you can go about diversifying your investment portfolio.
Thus investment diversification gives you the control over the risk of investment. You can minimize your losses on the one hand in times of unfavorable economics and on the other you can optimize your rate of return in times when the economy is in the boom.
So, Investment Diversification helps to create a portfolio that has multiple investments and goes on to reduce the risk of investment.
Let’s consider an example where an investment consists of stocks issued by a single company. If the company’s stock prices fall, your portfolio has to sustain the full brunt of the decline. It means that you have to suffer losses.
However, if the same investment were split between stocks from different companies, the risk of investment would have been considerably reduced.
It is how diversification helps investors by reducing potential risk to a portfolio. Whenever you go on to invest money, there is a potential risk involved. However, with Investment Diversification, one can considerably minimize that risk.
Why is it important to have a diversified portfolio?
Examples are the best way to illustrate a concept. And when the subject is related to money and diversification, it becomes even more useful to explain the importance of a diversified portfolio by taking you through with some examples.
Let us take an example of a person who has put all his money in bank saving account.
Now the main disadvantage of this type of investment is that the person is losing out on the rate of return advantage.
A saving account usually gives an interest of two to six percent or in many countries about no return.
Though this type of investment is low of risk, the interest earned by the investor here even fails to keep up with the rate of inflation.
So, there is no growth in the value of the money invested. The same person will benefit if he decides to diversify his portfolio of investment by including different investment options in his portfolio.
Let us suppose he now builds up on his portfolio to include fixed deposits, investment in the stock market, buy out some bonds, take an insurance cover and purchase out some gold.
This will now diversify his investment.
With diversification, he has now secured his life from any financial risk by taking an insurance cover. He has also invested in the stock market where he has a chance to gain a good return if the market flourishes or else if the market falls then only a part of his money is in risk.
Also, he has put some of his money as fixed deposit and thus increased the rate of return on the money kept in the bank. And also he had bought some gold.
This gives him the security in case if the stock market drops. The gold acts as leverage in times of need as well with its easy liquidity. The value of gold is always maintained and shows a healthy increase with time.
Let us take another example. Suppose a person has invested all his savings in the stock market. Here the person is taking a very high risk. If the stock market shows a downward trend and crashes, the person will lose all his money. He has to bear heavy losses.
Instead, if the person diversifies to include an insurance cover, investment in real estate, buy some gold and gold-related stocks, keeps some money in the bank as savings and as fixed deposit, he will manage the risk of investment in a better way.
Thereby he will ensure a good return on his investment, protection for himself and family and take a calculated risk of the fluctuating markets, while always maintaining a healthy liquidity in the form of savings and gold.
The above examples clearly illustrate the importance and usefulness of having a diversified portfolio. In bad economic situations, diversification will help to lower the risk of investment and thereby will help to minimize the losses. Whereas, when the economy is flourishing, diversification helps to optimize your investment.
How do you diversify your portfolio?
The crux of diversification lies in choosing a healthy mix of investment options. To begin with, a single balanced mutual fund would be a good choice. However, investors with large sums of money and looking to address more complex needs, require a well-thought strategy for diversifying their portfolio.
For such investors, diversifying with stocks, bonds, mutual fund, real estate investments, buying gold, and keeping some proportions of cash is a must.
As to stocks, you should focus on large, mid or small caps. Another good way to invest in stocks is to buy stocks of different industries or sectors. Additional choices include domestic and foreign stocks. It leads to minimizing losses and opens the door for substantial gains.
With Bonds, you can go with long-term issues especially when you are planning for retirement. Having said that, you should not invest more than fifty percent of your portfolio in stocks.
Moreover, you should always consider your risk tolerance level and personal investment objectives before choosing any mix of investment options.
Conclusion – Diversification is the right way to Invest
Thus as we have discussed above, the importance and advantage of diversification are clearly brought out in front of you.
By Diversification, you are clearly giving an advantage to yourself. On one side you first protect yourself, then save and finally invest. All these three measures of protection, saving and investment when clubbed together forms diversification.
So, Diversification reduces the overall risk level, gives you the capacity to overcome different market conditions and thereby help to increase the overall profits for you.
Diversification is a solution to ever increasing risks of investment. Diversification teaches us “not to put all of our eggs in one basket.”
If one basket falls, you have other baskets to look up to and depend upon. Diversification is the need of the hour for any investor who wants to invest wisely and smartly.