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How Does Diversification Protect Investors?


Investing can be a complex field layered with potential pitfalls and unforeseen risks, which is why so many investors seek diversification. The cornerstone of diversification is its potential to disperse risk. You can spread the risk of volatile investments or industries across multiple investments. It can be difficult finding the right diversification mix for you, though. That’s why we recommend consulting a financial advisor to assist in building a diversified portfolio as such a professional’s expertise can be invaluable.

What Is Portfolio Diversification?

Portfolio diversification is a calculated approach to investing that distributes your investments across diverse asset classes (ie., stocks, bonds, alternative securities), regions and industries. This strategy aims to reduce an investor’s vulnerability to any single asset or risk, potentially buffering them against substantial losses. 

A diversified portfolio contrasts with a non-diversified one because the latter focuses on a limited set of assets or sectors, potentially upping its susceptibility to market fluctuations. A diversified portfolio, on the other hand, attempts to turn this on its head by intentionally spreading investments.

Benefits of Diversification to Investors

Diversification can yield a bunch of benefits, a key one being potential risk reduction.  It is all about dispersing your investments across a breadth of assets and sectors. Contrary to traditional belief, diversification doesn’t guarantee risk elimination from your portfolio. Here’s what you need to know about potential benefits, though: 

  • Risk Reduction: Playing the role of a risk management strategy, diversification places a protective veil between your investment and the fluctuating market conditions. What it does, is offer a potential safety net against severe losses. 
  • High Return: There is the potential for you to earn a higher return, overall, because you’re reaping the benefits of multiple industries or types of investments. 
  • Invest in Multiple Markets: You don’t want to have all of your eggs in one basket, so to speak. You can also benefit from entering multiple markets or industries and learning more about them as you invest. 
  • Feel Safer With Risky Investments: You might be more likely to take some risks in your investment strategy because diversification can protect you against potential losses. 
  • Less Knee-Jerk Reactions: If you invest in the same asset and it takes a dive then you might have a quick reaction to take your money out. Diversification makes that less of a reality as you’re able to move forward confidently with your investment decisions no matter what happens.

Ways to Diversify Your Portfolio

Woman looking at her diversified portfolio on a computer.

Several strategies can help diversify your portfolio and the right type of diversification is going to depend on your appetite for risk and your long-term goals. Here are the most popular ways you can diversify your portfolio: 

  • Industries: You can invest in multiple types of industries, opening up potential better returns and protecting you from a single industry crashing. 
  • Asset Classes: You can invest in a variety of assets to protect against one, such as gold or stocks, declining. 
  • Countries: You can diversify across countries to keep your portfolio up even when one is bleeding money. 
  • Return Timelines: You can diversify your portfolio by when you expect to receive a return. This can help you earn income from your portfolio while investing for long-term growth. 

Implementing these tactics can infuse your portfolio with variety, thus dispersing potential risks and offering a broader range of potential returns. Keep in mind, though, that such diversification methods, especially when diversifying globally or across different asset classes, may benefit from the guidance of a financial advisor.

Risks of Diversification

Even diversification comes with its own set of risks. One risk is the possibility of lower returns than a more concentrated portfolio may experience because not all securities perform well simultaneously. This, however, is the essence of diversification: potentially balancing subpar returns from some assets with higher returns from others. 

Diversification may also require more hands-on management due to widened portfolios. In other words, an investor with a highly diversified portfolio will likely know less about what he or she owns than an investor who concentrates on a relatively small assortment of securities. In addition, diversification can lead to higher fees due to increased transactions. This can take more time or expertise to manage if you aren’t enlisting the help of a professional.

Finally, investing with diversification in mind could cost you more money than your previous strategy. It might be better for you in the end, but there might be more fees to make a variety of investments and you may be forced to pay fees to reinvest some of your short-term investment choices. 

Bottom Line

Couple talking about diversifying their portfolio.

Understanding diversification can be a helpful aspect of investing. It offers potential protection for your portfolio against market volatility and could provide possible gains. Yet, diversification comes with its own set of risks, like a lower awareness of what’s in your portfolio and higher expenses. Therefore, ongoing financial education matched with regular consultation with a financial advisor, can help investors steer the complex waters of investing.

Tips for Investing

  • Whenever you’re looking to protect your investments, you’ll likely want to make sure that you’re diversified. This could be hard without the help of a professional financial advisor. These advisors have experience in diversification and can help you find the right mix for you. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now
  • If you’re trying to find the right mix of investments for yourself, try using SmartAsset’s free asset allocation tool to see what your portfolio might look like. 

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