Diversification – Why You Are Better off Making Multiple Investments
Putting all your money on the same horse is bad advice for the financial markets. Diversifying your portfolio reduces risk and is thus incredibly important. Here is what you need to consider.
Diversification is indispensable when it comes to investing. Suppose you purchase stock in just one company. If the company goes bankrupt, all your money is gone. If you instead buy shares in 20 different corporations, you will only lose one-twentieth of this capital, should one of them become insolvent.
Actively distributing your investments involves much more than just investing in different companies, however. It is just as important to diversify your money by country, sector, currency, and asset class.
Invest in Several Countries and Sectors
As a result, it does not make sense for cautious Swiss investors to make all their investments in Switzerland and in Swiss francs. In order to stave off more risk, it is worth investing money in American securities as well, for instance. With the US dollar, you will then have two currencies in your portfolio. The US economy also relies partially on factors that differ from those in Switzerland and Europe.
It is just as important to invest in a range of sectors, since globalization has led markets around the world to increasingly move in the same direction. This means that diversification is more effective if money is invested in sectors that have as little in common as possible. For instance, developments in the pharmaceutical industry are entirely different from those of the oil industry.
Use All Asset Classes for Diversification
The same principles that apply for region- and sector-based diversification also apply for asset classes. Equities are heavily dependent on the general mood in the financial markets. If investors are worried, stock prices often fall around the globe. If, on the other hand, there is a lot of uncertainty in the markets, the demand for bonds rises – as does their value.
Real estate and commodities are subject to their own cycles of supply and demand. In turn, hedge funds and derivatives can employ strategies that counteract the markets. These two product categories can thus benefit from falling prices. Having a blend of different investments helps to mitigate the risk of one product class.
The More Varied, the Better
The amount of each product will depend on the investment strategy selected. People aiming for large returns will have a larger proportion of stock in their portfolios than an investor with a strategy focusing on reliability. The latter will, instead, place more emphasis on bonds.
In general terms, a diversification strategy is especially successful the less each investment correlates to the others. To give you a visual example, you could invest in both an umbrella manufacturer and a sunscreen producer. This would mean you would profit from extended periods of both sunshine and rain.
Diversifying Is Easier with Investment Funds
It is not easy for private investors to diversify their portfolios broadly enough. Especially if the amount invested is rather low, it is nearly impossible to buy into individual securities or investments that are sufficiently diverse. Continuously adjusting this mix to market developments can also involve a major expense in terms of time and fees.
This is where investment funds can come in handy. They offer a mix of different investments within a single product, and thus have a healthy amount of diversification. Depending on the focus of the fund, you can invest in stocks from different companies or directly into a combination of different asset classes.