You have heard this statement before, right? It is quite common to hear this statement when investing. The general rule is to not hold all of your money in one area. This simple quote is about diversification. The difference between having a diversified investment portfolio and an “one basket” portfolio comes down to risk.
Maximizing Returns With Diversification
All investors are trying to maximize their returns. That is the whole point of investing. While the concept of investing can be confusing for some, most understand that there is risk involved. Diversification can be the key to keep your risk lower. When you create a diversified portfolio, you can help deal with correlation.
Correlation is the concept of how certain investments react to market and economic conditions. This is measured on a scale of -1 to +1. Investments with a positive correlation react similarly. An example is as one stock goes up, the other goes up. Investments with a negative correlation react in an opposite manner. An example is as one stock goes up, then other goes down. There are also uncorrelated investments that react to different aspects separate from each other.
One of the easiest examples of negative correlation are stocks and bonds. They tend to react in opposite manners depending on the economy and market conditions.
For this reason, it is extremely important to create a diversified portfolio. You don’t want to hold all your assets in one area. Spreading them around is the best way to reduce risk.
Building A Diversified Portfolio
The next step in reducing your risk is building a diversified portfolio.
Many investors like to choose funds, which hold a group of stocks. This enables them to create a wider portfolio without picking individual stocks. Funds come in many different forms. You can choose from small, mid, and large cap along with offshore investment and domestic stocks. You can even pick particular industry sectors. These options allow investors to reduce their risk by investing in many different risk-level funds.
Bonds can be diversified as well, with the ability to choose from long-term and short-term, high-yield, and municipal. Each of these options can spread your risk around to create a truly diversified portfolio.
Remember To Monitor
Many still love the set-it-and-forget-it approach, but that is really not something that you should do when investing. Yes, diversification can help you with keeping your risk level spread out, but things change. Funds can start to deteriorate over time depending on the type of holdings and when markets change, so do the funds.
Investors should always keep track of their portfolios to make sure they are meeting their goals. There can be times when you need to reassess your goals and then adjust your portfolio. Monitoring your portfolio is important and should not be forgotten.
As you can see, diversification is an important aspect of investing. Investing is risky, but there are things that you can do in order to reduce your risk and spread it around. You never want to keep all of your eggs in one basket. Take the appropriate steps in order to safe-guard your assets if/when market conditions worsen. Your long-term financial goals will thank you.
Readers: What strategies do you use to diversify your investment portfolio?