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  • Writer's pictureAbir Mohammed

The Importance of Diversification & How to Do It

A common mistake among new investors is their lack of diversification. Many wonder why some investors make such huge losses whilst others seem to succeed no matter how the market performs - it’s all to do with how many eggs you have in your basket. Think of it like this: if you have too many eggs in one basket and that basket falls- you’ve lost most of your eggs. A vigilant person will always have their eggs spread across a number of baskets, or in an investor’s perspective, will diversify their stocks across different industries and markets.

Why do it?

As you have hopefully seen from the above analogy, an investor who doesn’t diversify puts themselves at a huge risk of a loss. If 100% of your portfolio is in the energy sector which crashes, then so will 100% of your investments. If instead, 20% was in energy and the rest in other markets, only 20% of your stocks would lose value, whilst the others might increase and balance out your losses or even return profits.

So the idea is that by diversifying your portfolio, you are less prone to the volatility of certain markets and can instead enjoy the rewards of investments at a lower risk. Historically, there is an abundance of data that shows how different parts of a market will vary in performance. Since it is so difficult to predict how a market may react to current affairs and events, it is sometimes advised to invest in lots of industries, so that some of those stocks are from the industries that do perform the best. This is a proven method that has worked countless times, especially in the long run.

How do you do it?

Diversification can take place in a wider number of categories. The first step is diversifying across different securities. The main securities include cash, property, bonds and stocks, each getting progressively more risky. The term risky in this case refers to the volatility and risk of making a loss. Due to the lower predictability associated with some of the later securities, they are often deemed to be more risky. Thus, it is essential to diversify across these securities. You wouldn’t want all of your savings kept as cash since it does depreciate in value due to inflation, however, since it is the most liquid asset, it can be very useful as an emergency fund and helps balance the higher risks of stock investing.

The second step to diversification looks more closely at stocks. It is essential to have stocks from multiple different industries within one's portfolio. This is because each industry is affected differently over time, thus spreads the risk across different markets. A more advanced though to have when doing this secondary step is to consider the % distribution of the sectors chosen that are secular or cyclical. Secular stocks are those that are not affected by the economic cycle, making them less volatile and thus safer. Therefore, if you’d like to play a safe game, invest in more secular sectors such as healthcare and energy, otherwise roll the dice and go for those cyclical stocks within finance or technology.

The third and final step of diversification looks more closely within sectors. It is advised that one balances the number of large cap, mid cap and small cap stocks according to how risky one’s portfolio is. Larger companies tend to be safer as they have more established foundations, however do also tend to have lower profits associated with them. Thus, it is important to invest in a range of different-sized companies to ensure appropriate returns on investments whilst retaining adequate levels of risks. An additional tip with diversification is to consider the weighting: that is, the amount of money you decide to put into each stocks. It is advised to have about 20 or 30 stocks in one’s portfolio, however what is more important is the allocation of money between these stocks, so do take that into serious consideration.

The Bottom Line

Diversification is a tool that has helped investors make billions over time. Some say that the difference between a person trying to make a quick bag from the stock market and an avid investor comes down to the differences in diversification. Remember also that the younger you are the more risky you can be, as you have more time to make up for any losses that are made. Thus, to conclude, calculate your risks accordingly and invest in different markets merrily.

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