Portfolio Diversification: Why it’s Important
Diversification is a useful technique that reduces risk by allocating investments among various financial industries. This practice is designed to help reduce the volatility of your portfolio over time, as well as maximize returns by investing in different areas that would each react differently to the same event. Additionally, when you diversify your portfolio, you are increasing opportunity to reach long-term financial goals while also minimizing risk.
Types of Risk
When investing, there are two types of risk investors face: undiversifiable and diversifiable risk. Undiversifiable, also known as systematic or market risk, associates with every company. This type of uncertainty affects the overall market, not just a particular stock or industry, and is both unpredictable and unable to be avoided when investing.
Diversifiable risk, also commonly known as unsystematic risk, is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business and financial risk. This risk can be reduced when investing by selecting investments that will be affected differently to stock market occurrences.
Ways to Diversify Your Portfolio
Fund variety is one form of diversification. It is recommended to begin with a broad-based index fund that tries to reflect the performance of the S&P 500. From there, you can amount that index fund with others of varying risk levels. Some funds could include:
• Purchasing shares in international companies
• Shares of small growth companies
• Investing in bonds
Each listed fund type performs differently under different market conditions. When you spread out your investments across these funds, you are more likely to have some stocks performing well at any point in time.
Another tactic of diversification is Asset Allocation. This investment strategy aims to balance risk and reward by dividing out a portfolio’s assets according to an individual’s financial goals, risk tolerance, and investment horizon. When you have variously different investment classes in your portfolio, which may include stocks, bonds, real estate, and other commodities, you are able to protect your portfolio from losing potential value if it only contained one failing asset category.
The Bottom Line
Diversifying your portfolio can help manage risk and reduce the volatility of an asset’s price movement. It is important to keep in mind, however, that no matter how well your portfolio is spread out in funds and/or assets, risk is inevitable. The main component in building your stock portfolio is to find a happy medium between risk and return. This ensures you can achieve your financial goal plans while having peace of mind about your investments.
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