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Investing in assets is appealing to many. It can offer the potential for wealth growth and building a passive income, and can also protect against inflation or reduced income from employment. Investing can provide a path to financial security and achieving long-term goals, although it can also result in financial losses.
Although all investing and trading carries a degree of risk (this is sadly unavoidable), risk can be minimized. One method of risk management is portfolio diversification. But what is portfolio diversification?
How Investment Portfolio Diversification Works
An investment portfolio is a collection of different investments. “Diversifying” your portfolio means spreading your money across multiple types of assets, like stocks, bonds, futures, options, and real estate. This lowers risk because if one investment does poorly, others can help balance it. This means that risk is divided.
For example, investing solely in real estate can leave you vulnerable if house prices fall. A more diverse portfolio could include instruments like stocks and futures (contracts that enable betting on the future value of assets).
Futures are popular among those looking to manage risk when investing. ES futures, for example, are tied to the S&P 500 index, which is linked to the overall performance of the dollar and the US stock market. These futures enable trading without owning the underlying stocks themselves.
However, also owning individual stocks can facilitate long-term growth and dividends (regular payments of earnings on stocks). The blend of investing in stocks and futures, as well as other assets like real estate, can balance risk and increase potential returns.
What Can Happen if You Don’t Diversify Your Investment Portfolio?
Investing all of your money in just one asset, or even one type of asset, can be like putting all of your eggs in one basket. If you don’t diversify, you’re vulnerable to big losses if one investment decreases in value. A lack of variety can leave your portfolio exposed to dramatic market swings, impacting your savings and financial goals.
There are plenty of real-world examples of this happening. As a result of the collapse of the subprime mortgage market in 2008, a major investment bank called Bear Stearns went bankrupt as a result of investing too heavily in mortgage-backed securities (similar to bonds).
When the “dot-com bubble” burst in 2000, the value of countless stocks in tech companies plummeted overnight, leading to devastating losses for many investors (many of whom were employees of tech companies who had invested heavily in their own companies’ stock).
These examples emphasize the importance of diversification. Overinvestment in a single asset or sector can expose you to significant losses if circumstances change for the worse. Diversifying across various assets can help mitigate the impact of such events.
Where to Learn About Diversification
Traders can access tips and advice from various sources. These include financial news platforms, online forums, investment websites, and social media groups. Many educational resources, books, and online courses offer insights into trading strategies, risk management, and market analysis.
Final Thoughts
Diversification and risk management are vital to mitigate potential losses in volatile markets. However, it’s crucial to remember that there is no way to completely eliminate the chances of losing money in financial markets.
Investment and trading always involve uncertainty due to unpredictable factors like market shifts, economic events, and geopolitical changes. However much research you do, and however smart your investments are, there is always a degree of risk when investing and trading.
