How to: Investing basics
The importance and opportunities of diversification
In this How to series, I will walk you through the basics of investing. As the series progresses, a more detailed and in-depth understanding will be developed so that anyone can start on the path to becoming a conscious investor with the funds they need.
In the first part of the series, we looked at conscious planning, the importance of saving, and the benefits of saving, i.e., investing.
In the second part, I discussed the most critical steps to starting investing: setting up the system and planning, including conscious attention to investing.
In the previous third part, I described the most common types of investments.
In the previous fourth part, I showed the risks involved in investing. Now, I will tell you about a risk mitigation option: diversification.
What Is Diversification?
Diversification is essential in investment management. It means investing your money in different assets instead of putting everything in one investment. By spreading your money across various investments, you can minimize the risk of losing all your money if one investment doesn't work out. A diverse portfolio of 25 to 30 stocks can help you reduce risks and cut costs. The ultimate goal of diversification is to protect your portfolio from significant losses by balancing out the good and bad investments.
Diversification Strategies
Numerous strategies are available for investors to diversify their holdings, and many of these methods can be combined to enhance diversification within a single portfolio.
1. Asset Classes
Investors usually spread their investments across different things and decide how much money to put into each. These things can be different kinds of stuff, and each has risks and chances for making money. For example, some things that people invest in are:
Stocks: Pieces of companies that anyone can buy
Bonds: Loans that governments and companies give out that have a set amount of money that they pay back
Exchange-traded funds (ETFs): A bunch of different investments that you can trade like one thing
Real estate: Land, buildings, and other things that happen in nature
Commodities: Basic things that people use to make other things, like crops or metals
2. Industries/Sectors
Different industries or sectors work differently. If you invest in a bunch of industries, it can reduce risks specific to any one sector. You can combine various types of businesses to spread your investments across different industries. For example, entertainment has two major types - travel and digital streaming. To avoid future pandemic problems, you can invest in digital streaming platforms (which are positively affected by more shutdowns) and airlines (which are positively affected by fewer shutdowns) simultaneously. Even though these two industries are unrelated, they could lower risk in your overall portfolio.
3. Business Lifecycle Stages
There are two types of public equities: growth stocks and value stocks. Growth stocks are companies expected to grow their profits or revenue more than others. Value stocks are companies trading at a discount based on their financial position.
Growth stocks are more risky because a company's expected growth may not happen. For example, suppose the Federal Reserve tightens monetary policy. In that case, less money will usually be available, or borrowing may become more expensive, making it harder for growth companies. However, growth companies could exceed expectations, generating even greater returns than expected.
On the other hand, value stocks are typically more stable, established companies. Although these companies may have already realized most of their potential, they usually carry less risk. By investing in both, an investor could benefit from the future potential of some companies while also acknowledging the existing benefits of others.
4. Maturity Periods
If you're considering investing in bonds, remember that the time until the bond matures affects its risk. Typically, the longer the time until maturity, the more the bond price will go up and down as interest rates change. Short-term bonds don't pay as much interest, but they're less likely to be affected by changes in future interest rates. Consider a higher interest rate if you're willing to take on more risk.
5. Physical Locations
Investing in foreign securities can help you diversify your portfolio. Suppose something terrible happens to the economy in the U.S.. In that case, it may not affect the economy in France in the same way. So, having some French stocks can protect you from losing too much money during an American economic downturn. But, to earn more money (and take higher risks), you should diversify across developed and emerging countries.
6. Tangibility
Investments like stocks and bonds are virtual and can't be touched. On the other hand, we have tangible assets like land, real estate, farmland, precious metals, or commodities that we can touch and use in the real world. These investments offer different benefits, as the tangible assets can be consumed, leased, developed, or used differently than virtual or digital assets.
However, tangible assets also have unique risks. For example, real property can be damaged, stolen, or outdated. Tangible assets may also require maintaining storage, insurance, or security expenses. Although the revenue generated from tangible assets differs from financial instruments, the costs of protecting tangible assets differ.
7. Diversification Across Platforms
Another aspect of diversification you might have yet to consider is how you're holding your assets. It's not necessarily a more considerable risk but an extra one you can reduce by diversifying. Platforms and account types offer different levels of insurance for the amount of capital invested, so it is recommended to open an account with more than one provider as the amount of capital increases to take this into account and reduce each provider's risk.
The Bottom Line
Diversifying your investments is a smart move when managing your money. The idea is to lower the risk of your investments by not putting all your money into one thing. Instead of investing all your cash into one asset, you can spread your wealth across different investments. Nowadays, investing and diversifying your portfolio online through various investments and strategies is easy. And remember that this can reduce the total return on a successful investment, but it reduces the impact on the total account value of a failed choice. As they say: something for something.
The Super Stocks Newsletter is provided for general information only. It should not be construed as an invitation or offer to purchase or sell any financial instrument, nor should it be considered a recommendation for any investment. More: Disclaimer