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It can be tempting to invest in every potential opportunity that you identify on the market. However, when balanced out with the rest of the investments in your portfolio, it is not always the most prudent thing to do. Constructing a portfolio and active portfolio management is just as much about not taking an investment decision as it is about making trades.
One of the reasons for this is down to successful portfolio diversification - but what exactly is that? And why is a diversified portfolio needed? Here, we look to answer those questions so that you can more successfully construct a portfolio that is likely to make you gains.
A diversified portfolio is one that is structured in such a way that risk is minimised and losses reduced as a result. It takes into account several different asset classes and how those asset classes perform in different ways during all parts of the economic cycle.
For, some asset classes are highly sensitive to larger economic movements, while others are more defensive. In short, to make a diversified portfolio, you need to have a mixture of asset classes that are either negatively correlated or not correlated with each other at all.
The hope with a fully diversified portfolio is to diversify away any risk that comes from too much exposure to one asset type. As a crude example, a portfolio with only two stocks in it is far more vulnerable to losing all its value than a portfolio made up of stocks, bonds, cash, gold and other investment types.
Additionally, it can be beneficial to diversify within asset type too - so with stocks it is good for diversification to invest in different industries and countries. With bonds, it is good to invest in treasuries as well as some riskier assets that will provide more of a return. The hope in employing diversification within asset classes is that you are further reducing your risk of big losses on days that the markets would otherwise be against you.
Portfolio diversification is worthwhile to conduct across your investments as a means to maximise your returns while reducing your risk. However, it by no means guarantees that you won’t lose any money at all - instead it simply hopes to lessen them over the longer term. In times, like we have seen in 2020, many asset classes react badly to a single event so that even the most diversified portfolio is likely to be hit in some way. But as a form of protecting downside, it is one of the most potent things an investor can do.
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