The number one goal of becoming an investor is to make money and in the process, not lose money. Achieving this goal involves dedicating sufficient time to studying different investment classes and understanding the associated risks. Seeking advice from a financial advisor or experienced investor for valuable perspectives is often one prudent step to consider.
At Viking Capital, we firmly believe in the fundamental notion not to put all your eggs in one basket, when it comes to investing. As expressed on dictionary.com, this principle is a proverb that cautions against investing all resources into a single entity, as it risks losing everything. For instance, refraining from placing life savings into a high-risk stock is a practical application of the proverb. The advice, “Don’t put all your eggs in one basket,” is a warning, urging individuals not to stake everything on a single venture or endeavor. This cautionary advice is why many choose diversification as part of their portfolio creation. This article delves into the advantages of diversification and avenues to create a diversified portfolio.
What is Diversification?
Diversification involves dispersing investments across several investment types, regions, and classes to mitigate the impact of poor performance in any one investment. The objective of a well-diversified portfolio is to expose you to new opportunities while decreasing overall risk.
Minimizing risk is one of the key benefits of diversification. Spreading your portfolio to several geographical locations and asset classes allows you to lessen the impact of an investment underperforming in one area while potentially thriving in another.
Portfolio Diversification
There are three main types of diversification to consider: asset allocation, sector diversification, and geographic diversification.
- Asset allocation- refers to the investment type; stocks, bonds, commodities, real estate, and start-ups.
- Sector diversification- refers to diversification within the asset class. For example; real estate can be classified as residential such as multifamily, commercial such as office buildings and hotels, or land; ready for new construction. Another example would be in stocks; healthcare, technology, or energy.
- Geographic diversification- refers to the physical location of the investments. This reduces risk by avoiding excessive concentration in any one market. Often investors select properties in the path of progress, areas that are not developed yet, where the city is intentionally targeting its economic growth.
How to Diversify a Portfolio
The first essential step when diversifying is to understand your risk profile. Your risk tolerance for the entire portfolio should align with your willingness to take calculated risks, taking into account the potential upside you aim to achieve. Once you have identified your risk profile, you can strategically allocate funds to various investments that align with your preferred investment style.
For instance, if you possess a lower risk tolerance, opting for bonds could be a strategic choice. Bonds provide the issuer’s commitment to return the face value of the security to the holder at maturity, minimizing risk but also limiting the potential upside. Another investment with lower risk is real estate, characterized by a low volatility level and the assurance that the property will always retain inherent value. In contrast, stocks lack such assurances, exposing investors to the risk of losing every cent invested. However, stocks offer a higher potential upside in returns. Typically, investors with a higher risk tolerance are inclined to invest in the stock market.
After you determine how much risk you are willing to take and set a financial goal to achieve, you can navigate investment opportunities by understanding their risk profiles. Like the examples above, no two investments are the same. Market conditions, economic turbulence, and time horizon are all variables that impact the stakes in an investment.
Conclusion
Crafting a diversified portfolio is essential for both novice investors and those with an established investment history. Once investors have gathered historical data on the performance of their investments, it becomes imperative to periodically rebalance the portfolio. This ensures that there is no overexposure to a specific asset, sector, or region.
A portfolio is dynamic and ever-evolving, comprising both foundational pieces and opportunities for growth. Some stocks may yield swift pay-outs, while certain real estate investments may contribute to generational wealth for the long term. Both approaches underscore the significance of diversification in investment strategies.
