Get to know the essentials of proper diversification of investments, which is the key aspect of building a prudent and responsible investment portfolio.
Diversification is one of the most important aspects that every investor should consider when planning their investments. It is a process that involves mixing the composition of a given investment portfolio by spreading investments across different assets or asset classes, such as stocks, bonds, commodities or precious metals. The goal of diversification is to reduce investment risk associated with concentrating all funds on one type of asset or within one industry or region.
Why is investment diversification so important?
Diversification is significant, because it helps to reduce the risk of loss and increase potential gains. If your portfolio contains only one position and its value decreases, this means a similar loss for the entire portfolio. On the other hand, if your portfolio consists of multiple positions, the decline in value of one of them will have a significantly smaller impact on the value of the entire portfolio.
How to build a diversified investment portfolio?
A diversified investment portfolio should consist of different asset or asset classes that are not closely correlated. In such case a decline in the value of one asset will not directly affect other assets in the portfolio. Below you can find some tips that will help you build a diversified investment portfolio:
1. Choose different asset classes
A well-diversified portfolio should include different asset classes, for example stocks, ETFs, commodities, currency pairs or precious metals. Each of these asset classes has a different level of risk and benefits. The lower the risk level of a given portfolio, the greater the negative correlation between individual asset classes.
2. Vary industries and sectors
Make sure that your portfolio provides exposure to many industries and sectors. For example, a diversified stock portfolio should include stocks of companies operating in independent industries, such as finance, healthcare, high-tech or energy. This way, you will avoid concentrating all your investments in one industry and in case of a crisis in a particular sector, your portfolio will be somewhat resistant to it.
3. Choose different geographical regions
Another important aspect is geographical diversification. This strategy involves investing funds in different geographical regions, which allows to minimize the impact of unfavorable events on a particular market or region. In such case, local political or economic turmoil will have a less significant impact on the value of your portfolio. Moreover, due to numerous innovations introduced in different parts of the world, it is also an interesting method for increasing potential gains.
4. Include assets of different risk levels
Different types of assets have different levels of susceptibility to market fluctuations. For example, during an economic crisis when stock prices fall, bond prices may rise, which contributes to balancing potential losses. That is why it is essential to include investment of different risk levels in your portfolio while achieving a proper rate of return.
5. Plan your investments with different investment horizons
Planning investment with different investment horizons is a good practice when building a portfolio. Diversifying investment horizons for given assets allows you to minimize the risk associated with a specific period of time. For example, investing in stocks in a short period of time can be more risky, because you are then more susceptible to periodic market turmoil. However, if you invest in stocks in the long run, the risk will fall relatively, due to the overall tendency for stock values to increase over time.
Diversification is a key aspect of building a prudent and responsible investment portfolio, where by spreading investment across different assets or asset classes, you can reduce potential investment risk. It is important to include various asset classes, industries or sectors, geographic regions, risk levels and investment horizons in your portfolio. The right balance between risk and potential returns will help you achieve your investment goals.