When you do your shopping at the local grocery store, do you ever stop to wonder why stores carry such a big range of similar goods? The explanation is quite simple: if one item goes through a seasonal decrease or is not liked by customers anymore, the other items will still sell. This business strategy is called diversification and is used by stores to protect their profits.
As you can see, diversification’s main purpose is not to maximize profits but to limit risks. The same happens with traders, investors, and their portfolios.
Whether you are a beginner investor or you already have tons of experience with financial markets, you need to understand the importance of portfolio diversification. When done properly, diversification helps investors mitigate risks and reduce portfolio volatility, allowing traders to slowly step out of their comfort zone and venture into new markets.
Diversifying your portfolio does not necessarily mean you need to learn how to trade on all the financial markets that exist. It means choosing a few assets you are comfortable with and spreading your resources across them. It can be two, three, or more, as long as you are comfortable with balancing all of these out.
Below, we will explore the importance of portfolio diversification, how to use it to your advantage, as well as the mistakes you should avoid while doing so. But first, let’s take a closer look at what portfolio diversification is.
What is portfolio diversification?
Portfolio diversification is a method traders and investors use to reduce risks. By allocating funds across a variety of financial instruments, markets, and industries, investors make sure that, in case one of these vehicles fails, the others will still be able to bring returns.
An experienced investor will understand that portfolio diversification is not a foolproof way to avoid losses but rather an important tool they can leverage to reach long-term financial goals by minimizing risks.
These risks can be broken down into various categories, based on the market and assets traders have in their portfolio:
- Volatility risks
- Liquidity risks
- Interest rate risks
- Company risks
- Inflation risks
No financial market is free of risks, so if financial safety is your ultimate goal, you need to keep one thing in mind: only trade money you can afford to lose. This way, even if a trade goes wrong, it will not jeopardize your financial security.
The benefits of portfolio diversification
Diversification can mean a variety of things. Some traders choose to spread their money across multiple asset classes, while others look to experiment with various investment methods. No matter how you choose to bring diversification into your portfolio, the overall benefits stay more or less the same:
As we discussed, risk management is the main reason traders and investors choose to diversify their portfolios. Let’s take stocks, for example. If an investor were to put all their money towards a company’s shares because it seems to be going very well now, what would happen if the company went bankrupt overnight due to an unexpected event? All money would be lost, and no profits would b made.
Finding a strategy that works
Investing and trading are often a trial-and-error experience. You learn from your mistakes, and you continue to experiment until you find a winning strategy. By spreading your money across multiple markets and assets, such as bonds, stocks, forex, crypto, or CDFs, you get to experiment, analyze various options, and find a strategy that works for you.
Exploring new markets
Financial markets are always changing, which is why it is important for traders and investors to constantly explore opportunities and keep an open mind. Take stocks and bonds, for example, which were very popular a few decades back. Now, traders and gravitating towards cryptocurrencies, forex, and other hybrid options. Many forex brokers are also MT4 (MetaTrader4) stock brokers, allowing traders to explore various opportunities and making diversification more accessible.
How traders can diversify their portfolio
Now that you have understood the importance of portfolio diversification, you are probably wondering about the methods you can use to do so. Truth be told, there is no exact recipe for success. Each trader needs to find the strategy that works for them based on their experience, financial goals, and funds.
Still, there are some general guidelines you can follow if you want to start diversifying your portfolio:
- Find balance: a risk-balanced portfolio ensures you have a higher chance to stand against market volatility. By including both moderate and high-risk investments into your portfolio, you minimize the risk of losing all your hard-earned money on one bad trade.
- Experiment with funds: once you manage to find a few assets that you like trading with, it is time to start experimenting with fund allocation as well. You will discover that some investment options require very little money, while others will only be profitable if you invest significant amounts. Remember, this is a trial-and-error process, so experiment with various options to find the ones that suit you best.
- Learn when to stop: we already established that financial markets are constantly evolving. This means there is a possibility some of your investment choices may stop being profitable in the future. When this happens, it is important that you act fast. Portfolio diversification is a continuous task, so if you see one or more of your investments stops bringing profits, it may be wiser to drop it and focus on different options.
Diversification is not free of mistakes
Diversifying your portfolio brings on an array of benefits. However, failing to do so properly can leave you open to mistakes that can take a toll on your finances.
While it is encouraged to try out multiple investment options, remember it will be very complicated to manage a large portfolio that includes multiple assets. Try out a bunch of options, but only stick to a few that you are able to manage.
Impulse decisions can also take a toll on your finances, so if you experienced a series of losses, don’t try to make up for them just yet. Take the time to learn and understand what you did wrong, then use what you learned to correct those mistakes.