Diversification is a powerful concept that helps minimize risk while promising returns. The wider your portfolio spread, the less dependent you’ll be on the unpredictable value development of individual securities.
“Never put all your eggs in one basket” is a popular idiom that is considered to be fundamental knowledge for investors. The phrase simplifies the concept of diversification and why it is so important.
Diversification is a method of allocating capital in a way that reduces the exposure to any particular risk. When we say an investment portfolio is diversified, we simply mean that the total investment capital is shared among multiple asset classes as a way to ensure that the returns come from more than one source. Diversification is a common practice that is highly encouraged because it reduces the risk of loss to your investment portfolio.
Asset classes perform differently under different economic conditions. When there is consistent growth in the economy, a low unemployment rate, and impressive business performance, most asset classes generally become a profitable investment as more people achieve upward mobility and can keep the market active.
Investing your capital in a mix of stocks and bonds is a basic way to diversify an investment portfolio. In a time of economic growth, the value of most stocks grows significantly, earning you great returns. On the flip side, when the economy is in distress, stocks take a hit and can lead to a significant loss in your investment capital. Bonds are low-risk investments that perform relatively well during economic decline, as they are not as affected by the market volatility as stocks.
So essentially bonds ensure your capital is preserved, and stocks grow your money. Since you cannot accurately determine how the economy will turn out over a period, it is always safe to keep a diversified portfolio to reduce the risk of losing your capital.
The stocks and bonds example clearly illustrates how asset classes are selected when building a diversified portfolio – a mix of aggressive, and conservative investment options, but other investments can be added to the mix to ensure the best outcomes.
How do i diversify?
Asset classes perform differently depending on market conditions, interest rates, currency markets, and the level of growth in the economy. No particular investment consistently outperforms other investments, that’s why it’s important to always have a well-balanced mix.
You can build your investment mix by investing:
- Across different asset classes – Fixed income instruments, cash and cash derivatives, tangible assets, derivatives e.t.c.
- Within asset classes – buying shares across different industry sectors.
- With different fund managers(if investing in managed funds).
- In multiple strong currencies – Eurobonds, OVERWOOD Dollar e.t.c
The Importance of Diversification:
Diversification comes with many benefits, but the major advantages include the following:
1. Minimising risk
Potential losses are minimized when the risk of your investment mix is balanced out. Diversification lowers the amount of risk you’re exposed to which inadvertently protects your portfolio from major losses.
If one investment performs inadequately over a specific period, other investments may perform better over that same equivalent period, decreasing the likely losses of your investment portfolio from concentrating all your capital under one sort of investment. OVERWOOD’s investment model is an example of an investment protected through diversification.
2. Capital preservation:
Diversifying your portfolio is an effective way to prevent losing your capital in the likelihood of the poor performance of an asset class. This investment strategy is particularly vital for those no longer in the capital accumulation phase of life.
Diversification is a procedure for securing the money you have access to by choosing protected accounts or fixed-pay speculations that guarantee the returns of the principal. OVERWOOD accommodates a protected, high return venture.
3. Generate returns:
Sometimes investments don’t generally proceed as expected, by diversifying you’re not only depending upon one source of income. This greatly increases your chances of getting periodic returns on your initial investment.
Ultimately, the goal should be to have your investment capital allocated in such a way that a decline in one investment does not lead to a loss of your investment capital as other asset classes should yield returns that offset the loss incurred on low-performing investments.