One of the tested and trusted ways to build wealth is to invest. Essentially, investments you make today could grow later in the future, therefore yielding returns as a result. However, there are also risks associated with every investment you make, which could lead to you losing all your money. The mitigation and control of these risks are called risk diversification and are what we would be looking at in this article.
What is risk diversification?
This is simply a strategy which investors use to manage risks. Basically, it involves spreading your money (investment) across several assets and in different industries. They do this in the hope that if any industry experiences a disruption, then others would prosper and ease the losses. Therefore, we can safely conclude it to be a case of do not place all your eggs in one basket.
Currently, risk diversification is practised by investors around the world and is generally accepted as a very wise thing to do. Since all investments carry some degree of risk, the least you can do is spread it because it cannot be avoided completely. Therefore, risk diversification helps you prevent overexposing yourself on the market. Also, risk diversification doesn’t simply mean you spreading your investment across several assets. To adequately execute it, you can spread across different companies, industries, specific products and sectors.
How can risk diversification be achieved?
You can achieve risk diversification through any of the following means:
Diversify in stocks:
imagine you create an investment portfolio consisting of stocks from a single company. This means that if that company does well, you’re going to earn a lot, but on the contrary, any downturn could reduce your portfolio to nought. However, by splitting your investment and investing in different companies’ stocks, you can completely reduce potential risks and also maximize returns.
Including bond and cash investments:
having a mixture of bond and cash investments in your portfolio is a very good way to reduce risks. Also, although many investors go for bonds and stocks, cash is handy to have due to its easy liquid state in case of emergencies or investment opportunities. Therefore, when developing your investment allocation strategy, including cash is a good way to achieve risk diversification.
Balance stocks and bonds:
the combination of stocks and bonds remains one of the most prominent investment strategies around the world. Therefore, regardless of whether you’re taking a passive or aggressive approach, having a decent allocation of bonds and stocks is always good. Also, most times, professionals create a balanced system that kinds of resembles a risk-reward ratio system. Basically, it is a system that offers you certain returns for your willingness to accept certain risks.
What are the disadvantages of risk diversification?
The major disadvantage surrounding risk diversification is what we call over-diversification. Although there are literally thousands of options to choose from, it is still important that you make the right choice, and playing it too safe by overspreading your investment could ruin your returns. Therefore, over-diversification would not allow any of your investments to make a significant impact. Instead, it would behave more like an index fund.
What are the benefits of risk diversification?
Risk diversification has the following benefits:
- It reduces volatility
- Minimizes the potential risk of loss to your portfolio
- Creates more opportunities for returns
- Protects you against adverse market cycles
As an investor, it is important that you understand and utilize the benefits of risk diversification. Although going all in for an asset could pose great returns, it could run you back to step one far too easily. Therefore, always balance your portfolio in a way that drastically reduces your risk for losses but also doesn’t affect your potential profits.