Why Is Portfolio Diversification Important To Understand Before Investing?
Before you invest in any market, one of the most important things to understand is DIVERSIFICATION. This is a technique that every investor follows that reduces risk by allocating funds among various industries and categories. Investment diversification is used to minimize loss and maximize return by investing in different industries that would react differently to the same event.
Why Is Diversification Important?
This is important because this allows an investor to minimize risk when one specific sector or industry crashes. Diversification is what keeps an investors portfolio balanced.
For an example, if you have a portfolio full of retail stocks and it was announced that all retailers were going on a strike and closing temporarily due to low wages being paid to employees, share prices of retail stocks will drop. Your portfolio will experience a significant drop in overall value.
However, if you have other categories in your portfolio other than retailers, that primarily compete with retailers such as companies that focus on online shopping and E-commerce, your portfolio will offset one another and still be balanced. There is a huge chance the companies that focus on online shopping will climb which hand in hand, will increase the overall value of your portfolio.
Although this is a form of diversification, you could take one step further by allocating different stocks in different industries. In the stock market, when one retail company drops, they all drop. When buying different stock, it is always best to diversify your portfolio by buying stock throughout different industries. An example would be:
- 10% Technology
- 10% Financial Services
- 10% Energy/Utility
- 10% Retail
- 10% Travel/Transportation
- 10% Automotive
- 10% Industrial
- 10% Healthcare
- 10% Consumer Staples/Discretionary
- 10% Telecommunications
- 100% Total
If you were looking to create your own portfolio, it will look similar to this. Keep in mind, you do not need to have all of the sectors listed above, but the more sectors you have, the more diverse your stock portfolio will be, which will minimize risk. You have to be careful to not over diversify. Usually what happens is, people put small sums of money in many different categories and the return isn’t that great. That being said, your strategy is created on a case by case basis.
There are other alternative for individuals that may not want to create their own portfolio, or people who would rather be hands off. You have the choice to buy a low-cost index fund which could be a Mutual Fund or ETF (Exchange Traded Funds). You will have to pay a small fee for this service but it is worth it if you would rather be hands off with your investments.
For more information about ETF’s and Mutual Funds, read Investing 101.
Asset Allocation plays a huge role in diversification as well. To follow-up on this blog post, I will post a separate blog this week that talks about the importance of asset allocation and how it could help improve the quality of your portfolio!
Please note: This blog is for informational purposes only.