What is diversification in investing and why is it important?
When it comes to investing, don’t put all your eggs in one basket!
What is diversification?
Diversification is a strategy investors can use to protect their portfolios (the investments they hold). It works by decreasing the level of risk the portfolio is exposed to, by spreading investments across a wider range of assets. That way, if the worst should happen and one asset’s price suddenly falls, the value of the overall portfolio is not unduly affected, because you spread your initial investment into other assets too.
An example could be the following: you have $1000 to invest and the idea of investing in Tesla stock sounds good to you. On the one hand, you could decide that because you’re so bullish on Tesla, you want to put all of the $1000 into that one stock. This is not a sensible approach, because in this example, all of your cash would be tied to the fortunes of a single company, thus, if the Tesla share price were to fall in value significantly, this is going to be more painful for your investment, because you have placed ‘all your eggs in one basket’ as the saying goes.
On the other hand, you could have decided to place $500 into Tesla, and the rest of the amount into other instruments, like a different stock (perhaps in a different sector of the economy) an exchange traded fund or some other kind of asset. This way, a fall in the price of Tesla shares is more likely to be offset by other more stable investments in your portfolio.
To a certain extent, diversification becomes more important as the amount of investment increases. With more money being invested, the risks of damaging losses can grow further as there is more at stake. Due to this, institutional investors (i.e. investment management companies) will often seek to broadly diversify the portfolios of their retail customers, particularly high net-worth individuals.
In more risky markets, such as emerging markets, diversification also becomes increasingly important. High volatility in emerging economies due to political instability, currency value fluctuations and other influences can mean that the level of risk for an investor looking to put money into an emerging market can be much higher, compared to ‘developed’ economies. As such, funds which look to invest in emerging markets may invest across many different sectors of the economy, reducing their exposure to volatility as much as possible.
While diversification is not a sure-fire way to prevent losses, it is a great way to balance risk and reward and reduce your exposure to risk within the markets. Think of diversifying as an insurance policy – one that can help to shield you from market volatility and reduce your concerns about your portfolio.
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