What is diversification and what are the main reasons to diversify when investing?

Whether investing, walking down the street, driving, or watching the sunset from the balcony, you are always taking a risk. Your personality and lifestyle play a key role in the risks you are able to take. Therefore, in this post, we will explain what diversification means and how you can diversify and get greater rewards. 

What’s diversification? 

Diversification is a risk management strategy that combines investments in a portfolio. When the market is growing, it seems impossible to sell a stock for any amount less than the price at which you bought it. Since the market is unstable, it’s important to have a diversified portfolio. 

We can better understand the meaning of diversification with the proverb "Don't put all your eggs in one basket". If we drop the basket, we will break the eggs. In other words, placing the money in different assets is more diverse and safer. This means, according to the proverb, that there is more risk of losing an egg, but less risk of losing all of them. However, having a variety of baskets can increase costs. 

We can also say that a diversified portfolio has a mix of assets such as stocks, commodities, real estate, lending, etc. And diversification works because all these react differently to the same economic event. Different investments will provide a higher return, that’s the idea. 

"My ventures are not in one bottom trusted nor to one place; nor is my whole estate upon the fortune of this present year. Therefore, my merchandise makes me not sad." — William Shakespeare, Merchant of Venice 

So, as we can see from Shakespeare’s quote, in any portfolio, an investment may do well and another does poorly.  

Theoretically, diversification allows you to reduce the risk of your portfolio without losing possible returns. And a well-organized portfolio has the lowest possible risk for a given return. If your portfolio is too much diversified, you must take an additional risk to achieve a greater potential return. 

Why you should diversify 

The purpose of diversification is not to obtain very high returns. Gains are not guaranteed and losses may occur. Nevertheless, this method does have the capacity to get you better returns at any level of risk chosen by you. So, there is a list of reasons why you should diversify: 

• The efficiency of the investments depends on its type; 
• You can create a portfolio, where the global risk is smaller than the combined risks of the individual assets; 
• The investments are affected in different ways by world events and changes in economic factors (like interest rates, exchange rates and inflation rates); 
• You are taking a bigger risk if you don’t diversify your portfolio. The average return will not be guaranteed higher if you accept an unnecessary risk. 

"Don't put all your eggs in one basket"

Diversification: 5 things you need to know 

If you want to have a diversified portfolio, you should look for different investments with different origins. This way, even if some assets are declining, the rest of it should be growing, or at least not declining that much. 

In order to help you with diversification, here are five things you need to know: 

1.Continue to build your portfolio 

Don’t forget to add on your investments on a regular basis. Follow the market so you’re not caught on its inherent volatility and minimize your investment risk by investing the same amount of money over a period of time.  

2. Never put your money in only one place 

It’s important to minimize the risk and the uncertainty, so don’t put all of your money in only one place (ie. one stock or one sector). If you invest in different assets, you'll spread the risk in tiny fractions, consequently, you can have greater rewards. 

3. Look for commissions / hidden costs

Be aware of hidden costs when you trade or when you invest in one asset A monthly fee or transactional fees are some examples of what you should looking for and that keep adding up, scraping away your gains. It’s important to pay attention to what you’re getting for what you’re paying. In other words, what you are getting for the fees you are paying.

4. Know when to get out 

The market is always changing and you must keep an eye out for it, because the changes can be very sudden and you don’t want to be caught in the landslide. It’s important to know when it's time to cut your losses, sell and move on to the next investment. 

5. Think about adding index or bond funds 

If you’re planning on using diversification in your portfolio, it’s a good idea to add index funds or fixed-income funds to it. Investing in assets that track various indexes makes a great long-term add-on for your portfolio. 

What you should know so far 

To achieve your long-term goals there are always some risks that you need to take, but they do not have to be unnecessary. As you saw above, diversification can play a bigger role in these long-term plans. It’s also important to choose the right combination of investments, keeping an eye on it and nourish it. This will make a big difference in the results you will get. 

Regardless of your purposes, your time horizon, or your risk tolerance, a diversified portfolio is the basis of any smart investment strategy. 

Thanks for reading.

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All the best,

Paulo Sá