Here’s how diversification helps reduce investment risk:
Reduces the likelihood of large losses: When you invest in a single asset, such as a stock, your portfolio is at risk if the price of that asset falls. However, if you diversify your portfolio and invest in a variety of assets, the chances of all of those assets falling at the same time are much lower. This is because different asset classes tend to move in different directions, so if one asset class is doing poorly, another asset class may be doing well.
Increases the chances of positive returns: By diversifying your portfolio, you can increase the chances of positive returns. This is because different asset classes tend to perform differently over time, so if one asset class is underperforming, another asset class may be overperforming.
Improves the risk-adjusted return: Risk-adjusted return is a measure of how much return you get for the amount of risk you take. By diversifying your portfolio, you can improve the risk-adjusted return of your investment. This is because you are spreading your risk across a variety of assets, which can help to reduce the volatility of your portfolio.
There are a few things to keep in mind when diversifying your portfolio:
Consider your investment goals: When you are diversifying your portfolio, you need to consider your investment goals. If you are saving for retirement, you may want to focus on investing in assets that are less risky, such as bonds. However, if you are younger and have a longer time horizon, you may be able to afford to take on more risk by investing in stocks.
Consider your time horizon: Your time horizon is also an important factor to consider when diversifying your portfolio. If you need to access your money in the near future, you may want to focus on investing in assets that are more liquid, such as cash or bonds. However, if you have a longer time horizon, you can afford to invest in assets that are less liquid, such as stocks.
Rebalance your portfolio regularly: As your investment goals and time horizon change, you will need to rebalance your portfolio to ensure that it is still aligned with your risk tolerance. This means selling some assets and buying others to maintain the desired asset allocation.
Diversification is an important part of any investment strategy. By diversifying your portfolio, you can reduce your risk and improve your chances of achieving your investment goals.