The Importance Of Having Diversified Investments
We can define diversification in this case as being a risk reduction technique. Investments are not made in just one channel. Different financial instruments or industries are normally covered with the main purpose of reducing the risk of loss.
Most of the professionals will tell you that diversified investments do not actually guarantee that you will not lose money but this is a huge part of long term financial independence. Let us go through all that you have to know so that you can understand why the importance is so high right now.
Image courtesy of [sheelamohan] / FreeDigitalPhotos.net
Risk Types You Will Have When You Invest:
- Diversifiable Risk – Also referred to as unsystematic risk. Diversifiable risk is associated to one industry, company, economy, country or market and appears since market events can have an effect on your investments.
- Undiversifiable Risk – Also referred as market risk or systematic risk. This type of risk is linked to the company and causes include exchange rates, war, interest rates, political instability and inflation rates. You cannot eliminate such a risk or reduced so investors need to think about diversified investments in order to protect themselves.
Why Do You Need To Diversify?
Let us think about one example. Let us consider the situation in which your investment portfolio only includes stocks for a railroad company. You receive word that the workers of the company go on indefinite strike. All trains are basically cancelled. It is clear that the share prices will drop. In order to counter such an unwanted and unexpected situation, you could invest part of your money in airline stocks. Since the railroads do not work, people need to get somewhere somehow so shares will go up there.
The really strong and successful investors will not only diversify investments through different countries. They will also think about other industries. The bottom line here is that you have to hold uncorrelated stocks.
You should also think about asset class diversification. For instance, if you invest in both stocks and bonds, reactions will be different when adverse events happen. By having a different asset class combination, the portfolio investment will not be sensitive to the swings of the market.
Diversified Investments According To Investment Experience
We are faced with different types of available choices when referring to diversified investments. The problem is that you need to diversify in a smart way. This can be quite difficult. If you are a person that does not have a strong investment experience or your fiancés cannot aid you in entering hedging activities, the best choice possible lies in bonds and stocks.
The most important thing that you have to realize is that you cannot actually prepare for events that are impossible to predict. Diversified investments do not reduce the loss that you will suffer but when you are smart about it, you will not take such a strong hit.
The investor finds it a lot easier to manage risk when proper diversification methods are used and the asset price movement volatility is reduced.