If you are a new investor, chances are you are getting many reminders to diversify. Don’t sink all your resources in one thing, experts will tell you. Spread out your money, say the experts. However, you might be inclined to wonder. Why should you diversify?
You diversify because you want to balance the risks of your portfolio.
Even the most reliable, consistent investments might crash and burn. Put all of your money into one, and you will watch it go away when bad things happen. In contrast, if you spread your resources around, you feel the loss of one thing, but the others can keep you afloat.
At the root of this mindset is the need to make sure your portfolio is spread across types of investments. This minimises your risks but does not guarantee you’ll never take a hit.
Diversifying also lets you reduce the impact of a volatile market.
A common mistake is to assume spreading your portfolio out is meant to increase returns. This is false. The real purpose is to minimise damage.
For example, if you had a highly aggressive portfolio, you are looking at something that is relatively narrow. Maybe the spread is 70% domestic stocks and 30% international. On a good year, you get a huge return on investment. In bad years, you can take losses as big as 68%.
For the average Joe, that is too much to endure. By altering your allocation and throwing in bonds and short-term investments, you create padding that absorbs some of the risks. This is especially useful for those who are risk-averse or on a fixed income.
Timed goals are also important to consider when diversifying.
What do you want out of your investments? Is it just to make money now? Are you looking for something more long-term, such as income for your retirement years?
Your goals determine how you should diversify. The further into the future your goal is, the more you’ll want to minimise risk over time. If you only plan to invest in a few things today, make a profit, and pull out, then diversification is less of a concern.