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Why Diversification Is Important To Your Portfolio

By Louis H-P on April 19, 2022

Reading Time: 5 minutes

Diversification is important and is investing in various types of assets to reduce your risk of loss due to any single asset’s underperformance. Hence, regardless of the upturns or downturns of any market, you’re guaranteed to make a profit. Markets are very unpredictable, and no amount of analysis can accurately predict how an asset will appreciate or depreciate. This is why pro investors will advise you never to put all your eggs in one basket but rather diversify your portfolio.

Key Takeaways

Why is diversification important

Less risk often means larger returns

Are you aware of all these options?


How does diversification work?

Diversification is a strategy of spreading out your investments and, consequently, your risks across different classes of assets. You can invest in stocks, bonds, and real estate simultaneously.

By doing this, you won’t be affected if one of your investments sees a downturn. For instance, if your real estate assets get frozen, or the stock market goes down, you’ll still have other investments to bank on.

Assets perform differently in different economic and financial circumstances. When you have various asset classes, you have more chances of getting ROI  from components of your stock portfolio in any economic scenario. So rather than concentrating on one trending market or industry, invest in several.

Benefits of diversification

1.   Minimizing the risk of loss to your entire portfolio

No one wants to lose all their money. Yet this is a possibility, even for promising assets. The only way investors can secure their wallets is to make sure their portfolio isn’t made up of only one asset – this gives you a margin of safety.

This is because when one investment performs poorly at a particular time, other investments could be skyrocketing. So if you lose on one, you gain on the other. Concentrating all your capital on one type of investment may give you massive returns if that investment skyrockets, but it may equally bankrupt investors if prices fall.

2.   Present you with more opportunities for returns

Technically, as stocks rise, bonds fall. So if you were to be investing in stocks alone, and for some reason, there’s a downturn, you’ll suffer a loss with no way to compensate for it.

If you had invested in both stocks and bonds, however, you’d have enjoyed the returns from your bonds while waiting for the stocks to rise again. This is one way investors stay in the game.

The same goes for traders, trading in one kind of asset may seem safe, but in the grand scheme of things, you miss out on potential massive returns. If you’re only trading in commodities like gold and silver, and you don’t trade currency pairs, you’ll miss out on potential massive gains when these currencies depreciate against the dollar (that’s if you’re selling).

3.   Protects you against unfavorable market cycles

Diversification is important due to bust and boom business cycle

It’s easy to invest in the winning team, greed often sets in, and investors put everything into a “bull market.” But then, the truth remains that today’s rising star may still become tomorrow’s falling star.

To save yourself from any unpleasant market surprises, you have to diversify your portfolio. It is the best safeguard against volatile market cycles.

4.   Preserving capital

Not everyone is in the market to stockpile profits. Some investors, mostly retirees, are seeking investments to preserve their accumulated wealth against inflation and perhaps make one or two gains here and there, as opposed to saving in the bank.

If you’re this kind of investor, the biggest mistake you can make is to put all your investments in one asset, industry, or company: Just one crash, and you can lose it all. Diversification helps you prevent this.

If you invest in Forex, cryptocurrencies, shares, and bonds, there’s no way you’ll lose all your savings. These are the fundamentals of preserving generational wealth if that’s one of your goals.

5.   Rest of mind

Having investment in different assets provides stability and, consequently, rest of mind. If the housing market sees a downturn, you save yourself months or even years of sleepless nights while you wait for it to recover.

But if such were to happen, yet you have millions stacked up in cryptocurrencies, you won’t have to worry because you know those kinds of assets aren’t dependent on the economy or housing market directly. Only smart investors venture into both nontraditional and traditional investments.

How to diversify correctly

Having multiple random investments doesn’t necessarily mean good diversification. There are specific strategies to apply to maximize results. One key strategy is to own investments that perform differently from each other.

For instance, stocks and bonds are said to be negatively correlated (as one rises, the other usually falls). So typically, a good strategy will be to invest in stocks and bonds. However, you’ll need to strategize further to determine how much of your capital should go into stocks and how much should go into bonds.

Here’s how to diversify your investments properly:

1.   Diversify across different classes of assets

An asset class is simply a group of investments with similar risk and return traits. For instance, stocks and bonds are two different asset classes. So when investing, go for investments that differ from each other sufficiently.

For example, as a trader, a good diversification plan is to trade on the Forex market and the crypto market. The chances of liquidity are very high on the Forex market than on the crypto market, and the crypto market offers you more options for trading as there are multiple cryptocurrencies available.

2.   Diversify within asset classes

Let’s say you invested in bitcoin in early 2021, around the time it spiked to $60,000, and you were expecting a bull run, only to see it fall to the price of $40,000 in 2022. The fact that you diversified into crypto assets doesn’t change the fact that you’ve suffered signing losses, all because you based your investments solely on bitcoin.

A better strategy would have been to invest in other cryptocurrencies like Ethereum, Solana, and other newer currencies. Within the time frame of bitcoin’s depreciation, so many other coins have experienced serious pumps.

So since you diversify across asset classes, you should also invest in different types of assets within the same class. Try to spread your investments across different industries and sectors, and also go for both budding startups and enterprise companies.

For instance, in the crypto world, new coins have the most potential for massive pumps. This is because, generally, small-cap stocks yield higher returns than large-cap stocks, albeit at a greater risk.

3.   Diversify across geographical locations

Diversifying across different locations is another expert move for your investment portfolio. For Instance,  a real estate investor shouldn’t only invest in one location. If you’re investing in company stocks, there are companies in lesser developed countries that offer a lot of promise.

Diversification benefits vary based on location. This is why so many companies keep their headquarters in first-world countries like the U.S., and yet their operations span across the globe. Investors can suffer losses when certain country laws and policies affect businesses adversely. So, never limit your assets, trades, or investment opportunities to a particular region or company.

Conclusion

Keeping tabs on all your diversified investments can be somewhat tasking. The strategy is not to have too many but rather a few well-diversified investments that you can leverage. “Bull markets” and “Bear markets” are inevitable. So the only way to protect yourself from market shocks is to diversify like a pro.

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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Louis H-P

Louis is a portfolio manager and a trader who brings a wealth of experience in private banking to The Lazy Trader. A fundamentalist and a trouble-shooter, Louis makes a firm contribution to the trading team.

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