Have you heard of the phrase, ‘Don’t put all your eggs in one basket’? It is applicable to investments too. How so?
Imagine that you have put a lot of effort into saving a substantial amount of money. You are eager to begin investing and see your wealth grow. Thinking it’s a sure-fire way to turn a quick profit, you decide to invest all of your money in one company’s stocks. You discover a few months later that the business suffered a significant setback, and the stocks of the company fell sharply, wiping out a sizable portion of your savings all at once.
Now imagine you had put 10% of your savings in the same stock, another 20% in gold, and the remaining in a mix of debt and equity mutual funds. Even if the stock fell, only 10% of your investment portfolio would have been affected. The remaining 90% could have still made a profit. This situation serves as a practical illustration of why it’s essential to diversify your investment portfolio.
Investing across many financial instruments, industries, and other categories is a risk management strategy known as diversification. This method aims to invest in several sectors that will produce higher long-term returns to maximise returns. According to most seasoned investors, diversification, the most crucial element of reaching long-term financial goals, minimises risk, even if it does not offer any assurance against loss.
Let’s look at five reasons why you should diversify your investment portfolio:
- Diversification Lowers and Spreads Risk
Risk minimisation is one of the main advantages of diversification. You are putting your entire investment portfolio into one basket when you invest in a single stock or asset. You risk losing a sizeable chunk of your portfolio if that investment underperforms or suffers a setback. You can lower this risk by distributing your investments across various asset classes and industry sectors. For instance, a decline in one asset class is less likely to affect your overall portfolio if you possess a mix of stocks, bonds, and real estate.
Moreover, diversification helps shield your portfolio from unforeseen circumstances. For instance, a recession or market catastrophe may impact some industries or asset classes more. You may spread the effects of a market slump and reduce losses by diversifying your investments.
- Higher Revenues
Diversification can result in higher returns, even though its primary goal is risk reduction. You can benefit from each asset class’s distinct qualities and performance patterns by spreading your assets among various asset types. Bonds, for instance, can offer income and stability, while stocks may have more significant potential gains. Mixing the two in a diversified portfolio can boost total returns while lowering risk.
- Assists in Achieving Different Investment Goals
When you invest in different asset classes, you can achieve different investment goals. For instance, if you have a short-term goal of going on vacation in a year, you can invest in debt mutual funds. This will give you stable returns while still beating fixed deposit returns. For a mid-term goal of paying a house down payment in five years, you could invest in hybrid mutual funds. For a long-term retirement goal of 20 years, you could invest in retirement mutual funds or the National Pension System.
- Hedging Against Market Volatility
Market volatility is inevitable, and diversification can help you mitigate the impact of market fluctuations on your portfolio. Investing in assets that behave differently under different market conditions can help protect your portfolio during market downturns. For instance, bonds and gold typically give higher returns when stocks decline. By including them in your portfolio, you can hedge your investments against different market cycles.
- Brings Mental Peace
When you diversify your investments, you can breathe easy knowing that all your investments will not tank at once. Diversification has many benefits, and you cannot understate peace of mind as one of them.
Diversification is a critical component of every effective investment. You can reduce risk and improve your chances of hitting your financial targets by diversifying your assets across several asset classes, sectors, and regions. Although no investment is entirely risk-free, diversification can help weather any unanticipated market volatility.
If you need help with financial planning, STEPS team of certified financial planners can help you tailor your investment plan to your specific financial objectives and risk tolerance.