If there is something you should definitely know when it comes to your investment, it is the importance of diversifying your investments – that is, spreading them across as many different types of investments as possible from physical assets, savings, and various stocks (check out Canadian stocks here).
A well-diversified portfolio reduces vulnerability to various investment risks and can improve expected returns. Another major advantage – diversifying and staying invested ensures a smoother journey to your destination. However, insufficient diversification of your investments can lead to undesirable side effects – from concentration to market risk. Diversification always plays a key role.
The Importance of Diversification
The focus is on two decisive advantages of diversification:
- First, a well-diversified portfolio reduces your vulnerability to various investment risks.
- Second, it can improve your expected return.
Just as an overly one-sided diet can be harmful to health, insufficient diversification is detrimental.
We all know the old saying that you shouldn’t put all your eggs in one basket … This is also a helpful symbol for investors. Firstly, you should have more than one basket and secondly not only put eggs in it – but also fruits, vegetables, cereals, meat or cheese.
Inadequate diversification of your systems leads to undesirable side effects:
- the excessive dependency on individual companies, countries or investment strategies
- changeable investment experience and
- a higher susceptibility to self-doubt regarding your investment decisions
These can cause unnecessary costs, lower returns and increased nervousness. There are carefully designed funds today that provide efficient, cost-effective access to capital markets around the world. Investing in a wide range of such funds is the best way to reap the benefits that global diversification has to offer.
How to keep the risks of the market under control
Let’s take a closer look at risk management. This is one of the main reasons why you should diversify your investment.
The most obvious risk is that of too much concentration. Even in a very positive market phase, also called the “bull market”, the price of a single share can fall. And even if the economy as a whole is flourishing, a company can become insolvent and the repayment of a bond can be at risk. With a diversified portfolio, you can avoid the risk of over-concentration.
You can avoid the concentration or cluster risk by diversifying, but not the market risk. In principle, the fluctuations of the entire market cannot be avoided. You should always take this into account when working on your financial security and planning a system. You should expect it.
Diversification becomes a scale on which you can see the right level of market risk for your individual financial goals.
But that doesn’t mean it’s easy to take the market risk. However, investors who remain invested even with increasing market risk can expect higher returns if the risk subsides. In the short term, however, they have to endure market fluctuations that test the determination of any long-term plan. This is exactly why you should take as much market risk as possible – but not more than necessary.
Regardless of whether we speak of concentration or market risk, diversification always plays a key role.
But there is another important advantage to take into account: diversifying and staying invested ensures a smoother journey to your destination. Short-term market returns, like a bucking horse, are characterized more by times of wild, violent price fluctuations than by steady trot. Diversification can help tame the horse.
So if some of your assets are performing poorly, it is likely that others will outperform at the same time, or at least remain constant.
Imagine three jagged, emerging lines that represent different types of stocks. Each one is like a bumpy ride. Taken together, the positive trend remains broadly, but the peaks and valleys are far less pronounced.
One of the reasons for this is clear: if one share rises in price and another share declines at the same time, this roughly compensates. Diversification is, therefore, a coherent and cost-effective strategy to control the desired results – without having to guesswork.
A helpful representation is the periodic table of investment returns – a color-coded table that shows which types of investments have been winners or losers in recent years. The only recognizable pattern is that there is none.
The benefits of diversification are now clear. In our third video, we cover how you can put together a portfolio tailored to your needs.