Diversification can be described as the only “free lunch” in the investment world. There’s no cost to diversifying, and it provides reduced volatility with the potential for increased returns.
To meet your long-term financial goals, it’s helpful to understand some of the specific benefits of diversification in your investments. Below, we’ll discuss those benefits in-depth, along with some key factors that may reduce your overall risk and potentially increase your portfolio’s long-term performance.
Benefits Of Diversification In Your Investments: How Diversification Works
To understand the importance of diversification in your investment portfolio, think of diversification as risk limitation. Your goal is to hold securities that aren’t similar to one another, securities that will perform differently based on their characteristics.
Instead of putting all of your money into a single company’s stock, you’ll invest in a range of stocks, mutual funds, and exchange-traded funds (ETFs), REITS, commodities along with fixed income products like annuities.. Markets are unpredictable, but a diverse portfolio spreads your wealth across different asset classes to provide steady growth and minimize the adverse risk of one company (or one sector of the market) getting hit particularly hard.
Here are a few important reasons to consider portfolio diversification:
1. Diversifying your investments limits the risks of individual stocks.
Stocks are an aggressive investment option, and the market can change dramatically in a matter of days or months. For example, in the first half of 2020, large companies like Apple, Google, and Facebook outperformed expectations, while small companies struggled. In the second half of 2020, those trends reversed.
You don’t want your portfolio to rise or fall based on the performance of a single type of company. A diversified portfolio might hold stocks from companies with both large and small market capitalizations (also called “large-cap” and “small-cap” companies) in different industries and across the world. With appropriate diversification, major changes in one sector of the market or in one country wouldn’t equate to major personal losses.
2. A diversified portfolio also includes low-risk “fixed income” products for stability and reduced volatility.
Stocks aren’t the only investment tool available, and portfolio diversification requires careful investments in other asset classes. If you’re getting close to retirement, you’ll likely want to have some portion of your portfolio invested in fixed income instruments, investments that provide steady periodic interest payments over time and return your principal when they mature. Unlike stocks, bonds rarely offer opportunities for rapid growth, but they’re much less volatile and may provide that needed stability when the market falls.
Not all bonds are created equal, and by investing in a mix of corporate bonds, US treasury bonds, short-term bonds, intermediate bonds, and inflation-protected bonds, you’ll build a more stable portfolio that offsets losses from your more aggressive investments. Remember, bonds can lose value if interest rates rise or a company is in trouble, so having diversification across different types of bonds and in different countries may provide the diversification needed.
Markets are unpredictable, but a diverse portfolio spreads your wealth across different asset classes to provide steady growth.
3. You’ll limit the risks of sudden market downturns.
Your financial strategy may also incorporate assets like real estate or commodities for an additional level of diversification. Real estate can respond to market conditions completely different than the stocks, so by investing in other types of assets, you’ll avoid putting all your eggs in one basket, so to speak.
Not only is having investments in different types of investments important, it is also very important to hold investments in different countries. Diversifying in other countries can provide protection from unforeseen events and will provide exposure to different currencies which can also mitigate your risk.. A financial manager can provide guidance for investing in international assets, including emerging markets, and make sure your investments include exposure to a variety of countries, not just one.
4. Your portfolio may outperform individual stocks.
Given the current market conditions, it’s tempting to look at high-performing stocks and wonder how much you would have earned by putting all of your money into one of those companies. Diversification limits risks, but doesn’t it also limit rewards?
Not necessarily. In many cases, portfolio diversification can provide a better long-term return than investing in individual stocks. No individual company can guarantee strong market performance in the long term, no matter how good it looks. There is always the potential for a market change, which can sour the performance of an individual stock, and if you have all your assets in one company, your finances may sink quickly with that company. A crystal ball for investments does not exist, if that were the case, we’d all be set. Instead, we recommend portfolio diversification, which limits risks while ensuring a steady return.
An experienced financial manager can help you create a diversification strategy that works for you.
Your diversification strategy should align with your goals. Younger investors may focus their portfolio on stocks rather than bonds, while older individuals may focus on a diversified portfolio with both stocks and fixed-income investments while preparing for retirement. If you’re a small business owner, you might want to limit your exposure to high-risk investments since your income comes from a source that may be high risk itself.
To create an effective strategy, you’ll need expert guidance. At Curio Wealth, we provide clients with personalized wealth management services to help them build diverse portfolios that limit risks. Schedule a call today to learn more.
