Diversification is a fundamental aspect of risk management and plays a critical role in building an investment portfolio.
When you first considered investing, it probably seemed like a good idea to focus heavily on what worked best for you from the beginning. If stocks from a particular company brought you high yields, why not double up on your original investment? The answer is diversification. It may seem counterintuitive, but diversification is a fundamental aspect of risk management, and plays a critical role in building an investment portfolio.
Effective diversification requires more than just purchasing a random bundle of investments. Otherwise, your investment may all move in the same direction in both up and down markets. Instead, investors might want to consider selecting securities that do not all move in correlation to each other. The U.S. Securities and Exchange Commission advises investors to diversify by asset category and within the asset category.
Diversify by Asset Categories
Asset allocation is the practice of dividing up your investment capital among different asset categories. This covers three main asset classes: stocks, bonds and cash. Some financial advisors consider this separate from diversification. Even so, the fundamental principle is the same and can be used in tandem with company-specific or industry-specific diversification.
While asset allocation may help to manage market risk, it does not provide a guarantee against market losses. It seeks to provide a cushion against market volatility .
Diversify Within Asset Categories
When it comes to diversifying within asset categories, financial advisors focus on spreading out stock among different types of companies. There are also different types of bonds to consider.
Yes, the portfolio may, at times, yield lower returns than those from investors who decide to specialize.
Putting These Concepts to Work
So, what steps can you follow to manage risk, especially as you draw closer to retirement? Here are a few tips to consider:
- Choose Investment Style: Investment styles further affect how you diversify your portfolios, so be sure to find one that works for you. Some of the most common options include small-cap versus large-cap, sector vs. industry, growth vs. value and domestic vs. foreign.
- Determine Asset Allocation: Deciding how much of your capital to invest in each category depends on a number of factors, such as your personal ability to tolerate risk and how soon you may need to liquidate investments. As an example, younger people may want more risk exposure, while people closer to retirement may want to err on the side of caution.
Sources:
https://www.finra.org/investors/investing/investing-basics/asset-allocation-diversification
https://www.bankrate.com/investing/diversification-is-important-in-investing/
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