There are a lot of buzzwords thrown around in the world of finance, and diversification is one of them. However, as business development professional Fahim Imam-Sadeque explains, diversification isn’t just a simple phrase that gets thrown around; it’s an essential aspect of any portfolio.
There are many reasons why it’s important not to put all your eggs in one basket when investing. Here are some of the main reasons why diversification is so important.
There’s no such thing as risk-free investing. Every investment comes with some risk, even if it’s minor. The goal of investing, though, is to take calculated risks and spread your risks out.
When you diversify your portfolio, you can mitigate significant losses in one holding. If you have all or a majority of your investments in that holding, you could suffer substantial losses to your entire portfolio.
For instance, airlines suffered tremendously at the outset of the COVID-19 pandemic. Restrictions kept people from flying at first, and many held off even when they were allowed to fly again.
If all your investments were in airline companies at that time, your portfolio likely would’ve suffered significant losses. However, if you diversified your portfolio to include airline stocks and other investments, you could’ve mitigated that risk.
Sometimes, other types of investments perform well when stocks perform poorly, and vice versa. When you diversify your investments to include different asset classes, you’re allowing yourself to take advantage of all the positives of every state of the market.
If all your investments were in stocks, for instance, you would perform well when the stock market is up and suffer losses when the stock market is down. Diversifying would allow you to reap the rewards of investing even when the stock market is down.
Combines Risk Levels
One of the main benefits of diversifying is combining multiple risk levels in one portfolio. This allows you to take advantage of all the different risk levels, no matter where you are in your life.
Younger investors who typically take more risks can still include some more moderate or safer investments in the same portfolio. Likewise, those approaching retirement age can still take some risks while playing it safe.
Being able to take risks with some investments and play it safe with others is how many people build their wealth over several years. They can even shift those risks as they get older and approach retirement age, yet still keep some risk so they can try to maximise returns.
Protects Multiple Asset Classes
Diversifying allows you to invest in multiple asset classes at one time. Think back to the example above of the airline industry. When times are good with travel, your investment in airlines is solid. When it’s not, you’ll need to rely on your investments in other asset classes to keep you moving in the right direction.
If you diversify, you can take advantage of this, so you’re not only all up or only all down.
Protects in an Asset Class
At the same time, diversifying allows you to protect yourself against one particular company within an asset class. As Fahim Imam-Sadeque explains, there are times when an entire industry does well, but one particular company does not — or vice versa.
Diversifying allows you to invest in multiple companies in a single asset class. This way, you can benefit from all that particular asset class has to offer, even if one of the companies you invest in doesn’t perform w