The Importance of Diversification in Investing
It may sound a bit cliché, but the adage “don’t put all your eggs in one basket” rings especially true when it comes to investing. In a perfect world, your investments would only increase in value day after day, month after month and year after year. In reality, there will likely be periods when some of your investments will underperform or even lose money, at least in the short-term. This is where diversification comes into play.
What is Diversification?
Diversification is one of the most important investment tools at your disposal. It is a risk management strategy that can help you balance the risk and reward of your investment portfolio. By strategically spreading your investments around to more than one asset and asset class, you can limit your exposure to the risk from any one type of investment. Diversification can help you reach your long-term financial goals while also helping to mitigate risk, and it can help you achieve the asset allocation most appropriate for your situation.
Diversification and Risk
When we talk about diversification in investing, we are talking about mitigating risk. For example, let’s say your investment portfolio consists of only shares of a tech company that produces today’s most popular smartphone and other in-demand gadgets. Maybe you’ve seen solid returns the last several years, and the company’s underlying fundamentals appear strong. But what happens to the company’s stock price if a competitor releases a more popular smartphone that eats up market share, or if there is a previously unknown defect in the company’s smartphones that causes millions to be recalled and production to be halted? What if a parts supplier can no longer supply the needed materials to keep production going or if the company is involved in a political scandal or illegal activity? These and any number of other factors could have a significant negative impact on the company and its share price, and the resulting losses can be devastating to a portfolio that is not properly diversified.
Diversifying your portfolio to include equities in other tech companies is a good start, but what happens if smartphones become obsolete altogether or the tech sector as a whole experiences a significant downturn? This highlights why it is also important to be diversified among not only different companies that are not correlated but also among different asset classes that may offer less potential return but could significantly reduce risk over the long-term. A diversified portfolio can include investments like individual stocks, Exchange Traded Funds, foreign securities, bonds, cash and short-term cash equivalents, and, depending on your situation, real estate, commodities and other investment vehicles. As an example, stocks and bonds are often negatively correlated, so when one asset class decreases, the other tends to rise.
Additional Thoughts on Risk
While a deep dive into the different types of investment risk is beyond the scope of this discussion, it is important to understand investing and risk go hand-in-hand, and there are several types of risk that can affect your investments. These types of risk include market risk, call and reinvestment risk, credit risk, liquidity risk, business risk, inflation risk, currency risk and political risk. Keep in mind that not all risk is diversifiable, and there is always the potential for losses when investing.
Diversification is one of the most important keys to successful investing, but it is still only part of the puzzle. You must also consider other aspects such as your financial goals, investment time horizon, risk tolerance and risk capacity. Speaking with a qualified financial planner can help you understand these facets and how they will help guide your investment decisions and asset allocation. This can give you important insight into which investment strategy is right for you.
Authored by Dennis Culver, Insight Wealth Strategies
Insight Wealth Strategies, LLC is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Insight Wealth Strategies, LLC and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Insight Wealth Strategies, LLC unless a client service agreement is in place.
Insight Wealth Strategies, LLC (IWS) and its affiliates do not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™, in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.