There is no such thing as a risk-free investment as even cash kept under your mattress has a chance of being stolen. But investment professionals have developed a number of strategies to minimize this risk and keep your hard-earned money safe.
Nick Lioudis, writing for Investopedia, defines diversification as a way to reduce risk by spreading investments.
“It aims to maximize returns by investing in different areas that would each react differently to the same event,” Lioudis added.
He explains that while not providing a guarantee against loss diversification can minimize risk.
Chris Muller writing for the advice blog Money-Under-30 explains that you need to diversify your portfolio in order to protect yourself against a market crash.
“In finance, diversification refers to the process of assigning capital in a manner that decreases exposure to risk,” he writes.
The thinking behind diversification is simple, according to Muller: An investment portfolio with different kinds of investments will yield higher returns with lower risk compared to any individual investment.
Exceptions to the rule
Of course, there are the exceptions to any rule as this Ask Traders post about legendary hedge fund manager George Soros explains.
Forbes contributor Karl Kaufmann explains that some of the greatest investors in history did not believe in diversification. He writes that an investor spreading himself too thing will compromise results and that diversification is not the optimum strategy if you are after more than average returns. He adds that this type of portfolio is a lot more work than one that is diversified because when your eggs are all in one basket “you should watch the basket like a hawk,” he added. “To repeat, this strategy is only useful if you intend to put the work into acquiring as much knowledge as you can about a few select investments,” Kaufmann added.
Another Forbes writer, Zack Friedman, adds that it should also be emphasized that investors like Soros put a lot of work into their decisions by doing research, building models and identifying catalysts that could influence share prices.
Consider different types of risk
Lioudis explains that investors have to deal with two types of risk.
The market risk applies equally to all company and is linked to factors like inflation rates, exchange rates, political conditions and interest rates. He writes that this is not a risk that diversification can protect against and must just be accepted.
Investors can protect against the second type of risk by diversification, he added. “The most common sources of unsystematic risk are business risk and financial risk. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.”
Why diversification minimise risk
“By diversifying, you’re making sure you don’t put all your eggs in one basket,” Louidis writes, explaining that this should be done by not only investing in different types of companies but also different types of industries. He also advises diversifying among asset classes as different types of assets, like bonds and stock, acts differently to adverse events.
Louidis adds that diversification also means spreading investments to different international markets and on some more complicated investment products to accommodate investors’ risk tolerance levels.
What does a diversified portfolio look like?
Muller writes that to create a diversified portfolio you should buy ETFs, index funds or mutual funds. ETF’s and mutual funds are investment products offering different stocks. He adds that a diversified portfolio should also include cash, bonds and exchange-traded funds.
He warns against trying to diversify by buying single stocks but instead advises to buy stocks across different sectors.
Muller also advises investors to choose investments with various rates of return.
He also advises investors to have some money in international stocks. “Stocks from other countries tend to perform a little differently and typically balance out a domestic-heavy investment portfolio nicely.”
Author of the best-selling book, Everyday Millionaires, Chris Hogan, writes in his blog that he advises investment over four types of mutual funds: Growth and Income, Growth, Aggressive Growth and International. He explains that these are all spread over different companies in different phases and also over different countries and includes investments with different levels of risk.
He explained that by investing in different mutual funds you will mitigate the risk of one underperforming. This way, Hogan argues, will provide you with the best protection against losses.
It is an on-going process
Muller adds that diversification is an on-going job and you should revise your options regularly – at least twice a year.
He adds that there are ways to automate the diversification of your
Costs of diversification
Louidis warns that while diversification is an excellent long-term investment strategy it may have higher transaction fees and brokerage charges.