Imagine putting all your eggs in one basket, only to watch in despair as the basket falls and all your eggs crack. If you had distributed your eggs into different baskets, you would have reduced your losses overall. This explains the concept of diversify your portfolio, and just how important it is.
The key to successful investing lies in finding the right balance between risk and reward, and diversifying your portfolio is the best way to achieve this. Instead of investing all your money in one place, this approach helps to spread your risk, meaning that losses in one area can be offset by gains in another.
There are different ways to diversify your portfolio:
- Types of Investments
This includes the different assets classes, such as stocks, options, commodities, ETFs, etc.
- Risk Levels
The amount of risk varies, and investing in assets with different risk levels can help balance out gains and losses.
- Types of Industries
Investing in industries with less or no correlation with each other.
- Foreign Markets
Products traded in foreign markets are less likely to be correlated with products traded in domestic products.
Let’s explore the benefits of diversification by using the example of diversifying the types of asset classes in your portfolio: Picture yourself as an investor who has invested $10,000 in two separate companies, allocating $5000 to each investment. One produces fast food while the other produces pharmaceuticals.
While both companies were initially doing well, the fast-food company eventually experienced a decline in demand due to health concerns. In contrast, the pharmaceutical company created a vaccine that has recently gained popularity among adults, leading to a boost in demand.
This increase in demand for the pharmaceutical company could help to offset the losses experienced by the fast-food company, pointing out the importance of diversifying investments across different sectors.
Diversifying your portfolio across different asset classes can help reduce risk and protect against potential losses. By spreading your eggs into different baskets, you can reduce the impact of one underperforming asset with gains in another. This way, you can increase the likelihood of achieving a healthy long-term return on your investment while minimizing the risks associated with any one particular asset.
The content published above has been prepared by CFI for informational purposes only and should not be considered as investment advice. Any view expressed does not constitute a personal recommendation or solicitation to buy or sell. The information provided does not have regard to the specific investment objectives, financial situation, and needs of any specific person who may receive it, and is not held out as independent investment research and may have been acted upon by persons connected with CFI. Market data is derived from independent sources believed to be reliable, however, CFI makes no guarantee of its accuracy or completeness, and accepts no responsibility for any consequence of its use by recipients.