Every individual who is new to the area of investments would have heard about Investment Diversification. The first advice given by any wealth manager or expert investor would be to diversify the investments. The diversification of investments is a technique used to experience fewer risks in any investment portfolio. It is a concept where you can invest parts of your money in different areas.
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How does Investment Diversification Work?
One aim every investor has is to reduce the risk of their investment. Usually, the nature of investments is volatile. No one can predict what’s going to happen next; they can just assume taking past performance into consideration. When an investor is putting their hard-earned money in any particular investment, they need to be prepared with anything either loss or profit.
In order to reduce the risk of an investment, it is suggested to invest in different portfolios as in, if you are investing AED 25,000, rather than investing all the money in a single portfolio say stocks, you can spread it in other portfolios as well like mutual funds, fixed deposits, gold, etc.
You can invest 60% of the investment amount in stocks, 25% in real estate, 10% in deposits and 5% in any small-term investment. Assume your stocks have gone up and the real estate market has fallen. Then you’ll have profits from the stocks to make up for the loss in real estate or any other investment. This is how diversification of investment work.
Each investment portfolio has its own advantages and disadvantages which work differently according to the atmosphere in the market. There can be an investment that is working great at that particular time but it is not predictable how economic conditions can work making it work adversely. Hence when there is another portfolio working on a positive note, it will compensate for the loss overall.
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Diversification vs Asset Allocation
Asset Allocation – As the name suggests, it is the process of allocating money into different asset classes.
This might sound similar to investment diversification but the simple difference between investment diversification and asset allocation is the strategy that is asset allocation is investing in different asset classes while diversification is how much percentage of your investment amount needs to go in a particular asset according to personal factors like age, risk appetite, investment goal and also market conditions.
Asset allocation is allocating the money into different asset classes like stocks, bonds, mutual funds, fixed deposit, gold, real estate, etc. On the other hand, diversification is the right mix of these assets and investing.
Advantages of Investment Diversification
Diversification is one of the important principles of investment. It is because you don’t have to rely completely upon a single investment. The advantages of investment diversification are,
- Minimizes Risk: The key advantage of diversifying investment is it reduces the risk. Even if one segment or part of investment doesn’t perform well, the other one can be in profits. In the investment world, there are two types of risks considered, Systematic Risk and Unsystematic Risk.
– Systematic Risk is when the whole market is associated with risk due to natural disasters, political instability, changes in laws, etc. Diversifying strategy doesn’t work in the case of systematic risk where the entire market is at risk.
– Unsystematic Risk is the risk associated only with a particular segment of the portfolio or a particular company. Such risks can be mitigated with investment diversification. - Increases Exposure: Through diversification, an investor can be exposed to a wide range of portfolios in the market. After a certain period of investment, they will be well aware of the portfolios that work for them.
- Multiple sources of income: There will be multiple sources of income when diversified. When you need a constant income source having a single investment can be a bit risky considering untrustworthy market conditions.
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Disadvantages of Investment Diversification
Every coin has two sides, similarly, there are some disadvantages with the diversification of investments as well.
- Expensive: Not all investment portfolios cost the same. Hence can make an investment in some portfolios expensive considering the additional costs added to it.
- Going overboard: Some investors go overboard while diversifying the investment. Investing in too many asset classes than the required can be difficult to manage and understand as well.
- Complicated: Each investment works in a different way hence it makes it quite complicated for an investor to understand the working and analysing the risk of the profile.
Investment diversification is a concept that works well when applied rightly. Not all investments move in sync. Diversifying provides stability and peace of mind for the investor. A famous quote in the investment world suggests, “Don’t put all your eggs in a single basket” and nothing can explain well about investment diversification. Hence keep calm and have your diversification game on.
Note: The views and figures used are just for informative purpose only. They are not indicative of current or future market trends.