Why should I diversify my investments?
Every investor should diversify their investments to manage risk. This means investing in various assets across markets as well as different assets within the market and reducing the amount of investment in one asset to invest in another.
How does diversifying differ from hedging?
Hedging and diversifying are both risk management strategies in investing portfolios but have significant differences. For one, hedging allows profitable investments to be leveraged against negative assets thus having the profitable assets compensate for losses on riskier investments. Having insurance would be one example of hedging against a possible risk. Diversifying is different in that the amount in an investment is reduced to purchase another investment, thus spreading risks through multiple investments.
For instance, in diversifying:
You own 50,000 shares of Stock A valued at $1 per share, for a total value of $50,000.
To diversify, you sell 20,000 shares of Stock A and use the $20,000 proceeds to buy shares in Stock B and C. Stock B is valued at $2 a share and you buy 5,000 shares. Stock C is valued at $.50 and you buy 20,000 shares.
You now have a diversified portfolio that manages risk by splitting the investments into three assets that will gain and lose value independent of each other. Hedging compensates for risk through the sale of stocks from competitors or other relatively risk-free investments.
How do I diversify?
The simplest way to diversify is to buy other stocks strategically. You will generally want to avoid stocks in an industry similar to the primary investment as losses generally spread through an industry as a result of news affecting the entire industry. It is unlikely that all stocks in a diversified portfolio will fall but one single stock or stocks invested heavily in a specific industry possess significant risk for the typical investor. It will sometimes be best to see the aid of a financial advisor if there are familiar with stocks that they can invest in to diversify their portfolio. The financial advisor will also be able to determine “risk parity,” which is the comparative risk of all assets in the portfolio and suggest ways to improve parity to the benefit of the client.
How will a diversified portfolio fare in poor market conditions?
Many studies have proven conclusively that most portfolios with multiple, diverse assets faced a lower standard deviation in annual returns, reflecting the relative stability diversity provides. The more stocks in a diversified portfolio, the lesser the impact of the stock, negative or positive, on the overall portfolio. Diversification of assets is almost certainly one of the best ways to manage risks outside of hedging, which will usually require the time and expertise of a financial advisor.
All investing carries risk and one should only invest when they understand these risks and have knowledge on their investment. If the prospective investor cannot identify company or industry then there is no hope that the investor will be able to make an informed and ration investing decision.