Portfolio Diversification Benefits
the benefits of portfolio diversification and why it should be the first step in investing...
Investing and investment strategies have been the most talked about topics for the last few months. From the local Starbucks coffee shop to the gym or even in around the dinner table, everybody has some opinion on how to invest in the stock market. And while many of those investing techniques do work it is very important to select the best one to fit your investment goal and the level of risk that you want to undertake. In fact, each individual should have his (or her) own investment plan because no one strategy will work for everyone in the same manner.
However, one particular approach should rank on the top of EVERYONE’s investment planning: diversification. Indeed, while there is no proven mathematical way of guaranteeing that an investment plan will perform in a certain way, it is the consensus among all financial consultants (and stockbrokers) that everyone should have a diversified portfolio.
Portfolio diversification is a rather simple investment strategy and the reasoning behind it is even simpler. The concept can be summarized in one sentence “ do not put all your eggs in one basket.”
In other words, one must make sure to spread his (or her) investment over a number of different sectors. By doing so, the exposure to one particular sector is reduced and so is the risk level that one person undertakes.
For example, assuming that we have $100 000 in investment money. We decide to invest $ 80 000 in technology stocks and the remaining $ 20 000 is invested into international mutual funds. While this portfolio may provide great returns in a booming economy it can also create extreme losses if the tech sector comes under pressure (such as the month April 2000). Indeed it is obvious that this portfolio should be more diversified in order to reduce the exposure to the tech sector.
Let’s now assume that the portfolio is diversified as follow $40 000 tech stocks, $20 000 retail stocks, $30 000 high yield bonds and $10 000 in international funds. This portfolio is much more diversified and even though it may not provide as good a return as the previous portfolio, it is also much safer and less prone to big money losses. Indeed, if the tech sector were to get hit the retail sector or the international funds could compensate for that loss and even produce larger returns. Furthermore, the investment into high yield bonds is a sure way of locking it a certain amount of profit in the diversified portfolio versus the previous one!
As we can see, the diversification approach has many benefits that should be taken into consideration whether you are a professional investor or simply someone trying to prepare for retirement by investing your money. In one case or the other, it would be foolish to risk your hard earned money without considering the benefits of such technique. Furthermore, it should be mentioned that portfolio diversification can also provide a good way of limiting your taxes such as capital gain tax or income tax. Many financial tools (IRA, tax-free bonds) provide a good way of differing taxes so once again, “don’t put all your eggs in one basket!”