The concept of investment diversification is certainly nothing new. The old adage “don’t put all your eggs into one basket” illustrates the concept perfectly. Diversification means that rather than invest all your funds in a single asset, you spread your money across different types of investments.
This certainly requires a bit of extra effort and cost. After all, it’s certainly much easier to monitor and manage a single investment and is to oversee a number of different investments. But the advantages of diversification greatly outweigh the downsides.
Here are some reasons why it’s important to maintain a healthy degree of diversification in your investment portfolio.
Diversification Protects You From Certain Risks. An individual who allocates most or all of their investment capital to a single investment or investment class is essentially taking an “all or nothing” approach. Unless you are a highly trained and seasoned financial professional, this type of approach is more akin to gambling than investing.
A highly concentrated or narrowly focused investment approach means that your investment can lose significant value based on the risks that are related to that particular investment class. A diversified approach is more insulated from any single type of risk, and is therefore more likely to provide a better return in the long term.
Diversification Provides Greater Flexibility. Furthermore, a diversified investing approach gives you greater flexibility to adjust your investments in the future. For example, with a number of different investments in your portfolio, you can pick and choose which winners or losers to sell in order to better manage your annual tax burden.
Furthermore, if you wish to shift your investment mix, or asset allocation, you’ll be able to choose which of your various investments make the most sense to sell, rather than being forced to sell part of a singular investment when the market conditions for that investment are unfavorable.
Diversification Makes More Sense for Retirees. Because diversification is generally a safer long-term investing approach, it is particularly well-suited for retirement savings accounts. Because your retirement plan will likely involve having to make withdrawals and take distributions as predetermined times, having the flexibility that a diversified portfolio provides will be much more preferable to a singular investing approach.
Diversification Helps Protects You From Bad Decisions. Finally, it’s important to understand that not all investment risks are external. Human nature plays a very large role in why many investors seem to fare poorly. Many of us have an inescapable tendency to jump onto “hot” investments just as they are reaching their peak, or to sell investments after a significant decline.
The harmful but prevalent “buy high, sell low” behavior can be seen time and time again. By diversifying your investment mix across a wide range of asset types and classes, you’ll be in a much stronger position to protect yourself from this self-destructive behavior.
Tags: Asset Allocation, diversification, investing advice
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on Wednesday, September 16th, 2015 at 3:11 pm and is filed under Asset Allocation.
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