Diversification is the practice of spreading your money out among various investments to reduce the likelihood of one investment causing your entire portfolio to decrease in value.
Investors should diversify their portfolio across different asset classes, sectors and regions to reduce risk and maximize potential returns.
Asset Classes
Diversification is the practice of spreading your money across a range of assets to reduce risk. The idea behind it is that if one investment decreases in value, others could rise in value to compensate and provide you with an even return.
Investors can select from a range of asset classes such as stocks, bonds, cash, real estate and commodities. Each has its own advantages and drawbacks and is exposed to specific asset-level risks.
Investing in a diverse mix of asset classes can accelerate the progress towards your financial objectives. Additionally, it reduces the likelihood that you’ll run out of funds before reaching those milestones.
A well-balanced portfolio should consist of both growth and defensive investments. If you have a long investment horizon, growth assets like stock may be suitable; on the other hand, if your timeframe is shorter, defensive investments such as cash or bonds might be more suitable.
Sectors
Diversification is essential for long-term investing success, regardless of your time horizon, risk tolerance or investment objectives. Diversifying reduces volatility and maximizes positive returns across your portfolio even when one stock or asset class performs better than another during certain times in the business cycle.
In addition to diversifying across assets, it’s also essential to diversify within sectors and industries. That means holding shares in companies from various industries that you believe may be affected by industry-specific risks like legislation, natural disasters or rising production costs.
The industrial sector, for instance, includes businesses that provide support services to other firms in manufacturing and shipping their goods. As such, it could be an attractive investment option for investors seeking low-risk ventures within a reliable sector.
Regions
No matter your objectives, risk tolerance or time horizon, diversification is a necessary component of any investment portfolio. It helps mitigate the ups and downs that investing can bring by having various investments that perform well at different intervals.
Regions are geographic areas that share certain characteristics based on human or physical factors. Geographers use regions to map and investigate how places connect.
Formal regions are geographically defined by shared attributes like language, culture, religion or economic activity. These boundaries tend to be well-established and well-defined.
Other examples of formal regions include climate zones, national parks, the French-speaking area of Canada, Southeast Asia and the Middle East and North Africa (MENA). They can also be defined by internal borders or political boundaries like the Rio Grande River that divides Texas from Mexico.
Time
Diversifying your investments is critical for minimizing the likelihood of losing all of your portfolio. Different assets perform differently at different times, which can help protect you in case one investment fails or one asset class performs poorly (like share markets).
Diversification can take many forms, but typically involves investing in various assets such as stocks, bonds, cash, real estate and gold. You can do this through mutual funds that buy and sell individual securities or index funds that purchase shares of a broad market like Standard & Poor’s 500 stock index.
Diversifying an asset class by investing in different companies and industries can provide protection from company-specific risks such as a decline in share prices from an industry like oil and gas.
