As a manager of your investment portfolio, you need to understand the importance of diversification. While you might wish for all your investment positions to increase in value, there will be times when some stocks incur losses. When this happens, you need other investments to offset the decline. Diversification ensures that you do not “put all your eggs in one basket,” thereby not exposing your capital to unwanted risks. Diversifying your investment portfolio in stocks is important as it prevents any part of your investment assets from being too closely tied to a single company or sector.
Diversifying Funds
Many investors diversify their investments by purchasing different types of funds. Advisors recommend starting with a diversified index fund that aims to simply mimic the performance of the S&P 500 index. You can then complement this index fund with some different funds that have varying levels of risk. These funds can include:
- Buying shares in foreign companies
- Comprising shares of growing small-cap companies
- Investing in bonds
- Buying shares in Real Estate Investment Trusts (REITs)
Each of these types of funds behaves differently in various market conditions. By spreading your investments among them, you make it more likely that you will always have some stocks performing well at any given time.
You can find analysis and information about mutual funds on sites like Morningstar. Brokerage firms typically provide what is called a “fund prospectus,” which any company offering a stock or bond for sale to the public is required to submit to the Securities and Exchange Commission. It is crucial to read the fund prospectus to make informed investment decisions.
Asset Allocation
Without a doubt, the most common form of diversification is asset allocation. By having elements from different investment classes in your portfolio—including stocks, bonds, cash, real estate, and gold or other commodities—you can protect your portfolio from loss of value that might occur if it only contained one asset class that fails.
When stock prices fall, for example, bond prices often rise as investors shift their money to a less risky investment. Therefore, a portfolio containing stocks and bonds will behave differently than a portfolio containing only stocks during a downturn in the stock market. While your portfolio may not rise as quickly as it would with a portfolio containing only stocks, it protects you from severe losses.
Diversifying Asset Classes
It is also wise to diversify within asset classes. Investors who heavily invested in technology stocks in 2000 lost a significant amount of their money when the internet bubble burst, and technology stocks rapidly declined. Similarly, financial sector stocks suffered in late 2007 and early 2008 due to the subprime mortgage crisis. If anyone were exclusively invested in these assets during those times, they would have faced substantial losses.
And while it may seem risky to put most of your money in one sector, it is even riskier to do the same in a single stock. That is what many investors did in the late 1990s, as many employees in tech companies allowed their stock holdings to become heavily weighted in their employer’s shares. These portfolios with a single stock were, in fact, akin to portfolios reliant on flagpoles in the 1920s, where they soared high in the air with only a long, narrow pole for support.
Consider anyone who was significantly invested in Amazon at the turn of the millennium. In December 2000, Amazon shares were selling for over $100. By the following October, they had dropped to less than $6. If you were relying on those shares at the time, you might have found yourself in an unpleasant surprise. It wasn’t until December 2007 that they rose to nearly $90 again.
Conclusion
The two steps
The two basics of diversification are to spread your money across different asset classes and then to distribute that money within each class. A smart approach for individual investors is to diversify using mutual funds. Since mutual funds are pools of stocks, you will be diversified somewhat automatically. A financial advisor can help you choose the mutual funds that align with your desired level of risk and diversification.
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Sources:
U.S. Securities and Exchange Commission. “What Is a Registration Statement?”
Macrotrends. “Amazon—23 Year Stock Price History | AMZN.”
Source: https://www.thebalancemoney.com/the-importance-of-diversification-3025567
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