Diversify my portfolio? Why?
If you listen to professionals (which I usually do, they’re called professionals for a reason), they tell you not to “put all your eggs in one basket” and only get one type of stock or mutual fund from one place. Diversification is the best way to success.
But why? Why is it less risky to distribute the $10k that you’re investing between 10 different companies instead of just one? Well, that’s what we’re going to explore today.
Diversification reduces risk. This is the single biggest reason to diversify. If that company that you’re investing your $10k in goes under, or their stock values fall because of a court decision or a big business mistake, you are going to be out a lot of money. Diversity in your stocks gives you somewhat of a cushion in case one of those companies have issues. We’ll look at this mathematically.
Using the example above, let’s say that one person invests $10,000 in one company. That company’s stocks fall, and they end up losing $4,000 (40%) of what they invested. They’re left with $6,000 in hurting stock, and the forecast for that company isn’t very positive, so they bail with just $6,000.
But, another person invests in 10 different companies, $1,000 each, one of them being the same company that the first person invested the whole $10,000 in. The above-mentioned company falls, and that person loses $400. Yes, the person still lost $400… or did they? Let’s explore this in the next reason.
Diversification increases profit… most of the time. This is where you have to be aware of certain things (which we will discuss more in another point), but if you are aware of these, your profit will be at its maximum with a minimum risk.
Continuing on the example above, the second person lost $400 because of stocks falling 40%. But, another company that this person invested in just increased 10% (making that total ($1,100), another increased 15% ($1,150) and another increased 20% ($1,200). The increased value of the other stocks has now more than made up for the $400 loss in the first stock. They may still bail their stocks out from the company that they lost $400 on, but overall, they actually made another $50 off their portfolio as a whole.
Diversification increases experience and awareness. Think about it. If you are dealing with a bunch of different stocks, then you’re going to have experience working with different companies and different indices. This in turn gives you the knowledge you need in order to better plan for the future. Also, you are not just watching one company; you are watching multiple companies in multiple industries, thus increasing your awareness of companies other than those you originally invested in. This will help you make better decisions for your investments in the future, and possibly help you to further diversify your portfolio for a maximum profit.
Back to our example: Sure, the first person gained the experience not to “put all their eggs in one basket,” but at a high cost. The second person’s experience could teach them the following:
- Not to put all of your investments in the same industry (if you look at futures, some industries just have a better longevity than others. Most of the time, the companies within an industry experience the same kind of changes at the same time).
- What companies are a good risk to take and what ones you should steer clear of. Sometimes, it’s a great idea to take a risk on a newer company, help them establish some revenue, and then watch them take off. Sometimes it’s not. Having a diverse portfolio will help you pay attention more to these kinds of things.
- When to stay or go. You won’t hold onto a stock forever, but sometimes you will increase your investment in a certain company or pull out and switch to a different one, and that’s okay. This is how you should work the stock market.
- How to reinvest your increase or the money you pull out.
So, as you can see, a diverse portfolio is a great idea. This is why some investment companies offer you different ‘packages’ of stocks and such. Your money needs to be all over the place to minimize risk, maximize profit, and just overall make you be a better player in the stock market.
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