It may not be well acknowledged, but most people actively participate in some form of investment. You see investments do not always have to be stocks, bonds or other securities. The local bank paying out interest on deposits is a form of investment, and so is owning real estate. Irrespective of whether you actively or passively manage your funds, it is important that you acquire a diverse portfolio. In general the more diverse a portfolio is, the less it will suffer from volatility, which inherently reduces the risk you face.
The first step to diversification is to ensure that you have invested in a wide array of asset classes. These can include stocks, bonds, property, and term deposits. In the event one asset class crashes, you may not suffer from such heavy losses.
Unfortunately over the years we have seen many well established companies come under sudden misfortune and collapse (Enron, Lehman brothers etc). Those investors who did not manage to escape in time, got their fingers burnt badly, However their loss would have been partially mitigated if they had invested in a wide array of firms and asset classes. In this way a diverse portfolio could help to preserve your capital.
In order to obtain a thorough understanding of the benefits of diversification let define a few things.
Unsystematic risk, is the risk that is unique to a particular company e.g. the resignation of a CEO due to controversy surrounding their involvement in a money laundering scheme. In this instance only the company’s share price will be affected by this news. Other stocks will most likely not respond to this information.
Systematic risk, is the type of risk that will impact all securities across the market e.g. falling oil prices or a property bubble such as those seen in the 2008 global financial crisis. In these situations diversification will have no real impact on the stability of your portfolio.
The illustration above represents the relationship between the number of securities (i.e. stocks, bonds, and options) a portfolio contains and the overall risk a portfolio might face.
The optimal level of diversification within a portfolio appears to lie around the 20 mark. It is at this point that over 90% of the unsystematic risk has been diversified away. Increasing the number of securities beyond this point may lead you into trouble, as you are left with the burden of managing so many variables with little rewards from the increased diversity. Being over diversified, might see you miss an important piece of news about a firm, or it might prove to be difficult to move all of your funds out of exchanges quickly in times of economic difficulty.
In today’s world an investor has so many resources in front of them to learn the ways to invest in the most efficient and productive ways. However, did you know there are professionals out there who are trained in investing and giving investment advice? That’s right, booking a meeting with a trusted financial adviser to discuss your options can be of great benefit. Best of all most if not all financial advisers do not charge you for a meeting.
Having a diverse portfolio is of supreme importance, if you want to maximise returns while minimising risk. This involves investing in a variety of asset classes and a variety of firms from differing industries. Do note that trained professionals in the form of financial advisers are always there to help you if you need a valuable resource to lean on. This will make the process of creating the perfect portfolio a breeze. Hope you have learned something from this article today, and happy investing.