Investing is one of the most effective ways to build long-term wealth, but how can you maximize returns while minimizing risk? While there’s no one-size-fits-all for everyone, there is a key strategy that can help balance risk and reward in your investment portfolio: diversification.
At first, diversification may seem complicated. What is it? What are the benefits of diversification? How do you diversify your portfolio? And how diversified should your portfolio be? We answer all these questions, and more, in this blog, so keep reading!
What Is Diversification?
If you’ve heard the old-age proverb: “Don’t put your eggs in one basket”, then that summarizes the basic principle of diversification, which signifies having eggs in multiple baskets so that you don’t potentially break all of them. So, in terms of investing, diversification essentially means spreading your investments (eggs) over various asset classes (baskets), so that you’re not overexposed to a single investment.
The reason being that putting your hard-earned money into one company can be extremely risky, especially if that company goes bankrupt, or the asset’s value plummets! That said, if you invest a major chunk of your money in a particular asset class, then you expose yourself to potential losses of that asset class, much like watching all your eggs break once your basket falls down!
By diversifying, you reduce the risk so that one asset’s performance doesn’t affect your entire investment portfolio. That way, you’re able to cushion the effects of market volatility and hedge against potential losses. Though diversification doesn’t guarantee against loss, it does protect your capital as it reduces the portfolio risk associated with investments, without costing your returns.
Benefits Of A Diversified Investment Portfolio:
Portfolio diversification has several benefits, but to fully understand how diversification can be beneficial, we’ll give you an example. So, let’s imagine that you’ve invested in stocks, and the stock market crashes. Well, that’s your entire portfolio’s value wiped out in an instant!
However, if you had diversified with stocks, bonds, real estate investments, and gold, for example, then you’d reduce the overall risk to your portfolio so that no single investment can drastically wipe out its value. By allocating your capital to various asset classes, you’re protecting your capital as well as enhancing your chance at risk-adjusted returns.
So, let’s recap the main benefits of diversification:
- Risk Reduction
- Capital Preservation – as opposed to just capital appreciation
- Risk-Adjusted Returns
How To Diversify Your Portfolio?
Since each individual investor has different financial goals, risk appetites, and time horizons, there’s no one way to go about diversifying a portfolio. Your diversification strategy ultimately depends on how comfortable you are with the risk you’re willing to take, and how your asset allocation could impact your timeline and financial goals.
For instance, if you’re nearing retirement, or relying on a steady source of income from your investments, then investing mainly in stocks and crypto might not be the most suitable decision, considering how volatile those markets can be. In said cases, you’d be shifting money out of such volatile markets and looking into more conservative investment alternatives, like real estate.
Remember, while diversification helps minimize risk and enhance your returns, an over-diversified portfolio might make it difficult to track your investments and generate reasonable returns. That’s why it’s important to find that sweet spot when considering where to invest, be it in equity, gold, real estate, stocks, bonds, and so on.
In terms of how diversified your portfolio should be, then just keep in mind that there is no magic button that tells you if your portfolio is well-diversified enough. However, a basic rule of thumb is to invest in assets whose returns aren’t highly correlated with one another. That way, if a market downturn affects one sector, it either doesn’t affect other areas in your portfolio.
Types Of Diversification:
One thing to note is that there are two ways to diversify your portfolio: across asset classes and within asset classes. The diversification examples we shared above refer to diversifying “across asset classes”.
On the other hand, when you diversify “within” a single asset class, you spread your investments within that asset. For example, real estate investments allow you to own multiple properties in various areas that perform differently, from long-term to short-term rentals. That way you have property type diversification, as well as geographic diversification if they’re located in various areas, meaning that you have assets (properties) that are likely to perform differently depending on the market conditions.
In A Nutshell
We hope you now understand how important it is to implement a portfolio diversification strategy as a prudent investor. The key thing to take away here is that diversification minimizes portfolio risk because if one sector performs poorly, another might be doing well enough to offset major losses and still maintain risk-adjusted returns. So, while we can’t time the market, it’s wise to spread out your investments over time so that those stomach-churning ups and downs are kept to a minimum!
With diversification, it’s equally as important to diversify within the asset class as it is to diversify across asset classes. What’s great about real estate investing platforms like SmartCrowd is that they allow you to diversify across multiple properties located in various areas all over Dubai, therefore giving you the ability to spread your portfolio risk. Be sure to check out our latest investment opportunities on the platform or download our app!
Remember, your diversification strategy should be tailored to your financial goals and risk tolerance, so if you’re uncertain about how to diversify, then consider consulting an investment advisor.
Disclaimer: This blog is intended solely for educational purposes and shouldn’t be treated as financial advice. We suggest you always conduct thorough research, perform your own due diligence and consult with financial advisors to assess any real estate property against your own financial goals.