Why a diversified portfolio is so important
Many people are losing money because they don’t follow the basic rules of investing. One of the most important rules is to diversify. In this blog post, you’ll learn what diversifying means and how to use it to set up your portfolio in an ideal way.
Good investors know that only a diversified portfolio is a healthy portfolio. Ray Dalio, another successful investor, and famous hedge fund manager, lives for the all-weather portfolio. A portfolio that is prepared for all types of weather — of course, not rain and sun but related to the investment markets.
Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Let’s have a look at why this is true and how to accomplish diversification in your portfolio.
An example of a diversified portfolio:
Let’s look at what happens when a portfolio is not diversified.
Say you have a portfolio of only airline stocks. If it is announced that airline pilots are going on a long strike and that all flights are canceled, share prices of airline stocks will drop. Your portfolio will experience a noticeable drop in value.
If you counterbalanced the airline industry stocks with a couple of railway stocks, only part of your portfolio would be affected. There is a good chance that railway stock prices would climb as passengers turn to trains as an alternative.
But you could diversify even further, as many risks affect both rail and air because each is involved in transportation. An event that reduces any form of travel hurts both types of companies — in statistics, you would say that rail and air stocks have a strong correlation.
Therefore, to achieve superior diversification, you want to diversify across the board, not only different types of companies but also different industries.
Here are a few examples of different asset classes you can diversify into:
- Stocks
- Bonds
- Real Estate
- Gold
- Commodities
- Cryptocurrencies
Different assets, such as bonds and stocks, do not typically react in the same way to adverse events. A combination of asset classes should reduce your portfolio’s sensitivity to market swings.
Generally, the bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will likely be offset by positive results in another.
Cryptocurrencies are closer to stocks than to bonds or traditional banking products. According to Forbes, most experts agree that cryptocurrencies should take between 2 and 5% of your portfolio if you manage it completely. However, using a service provider with a good and stable product could be more. And if this service provider offers a continuous cash flow or passive income, it could be even more, like 10–20% of your portfolio.
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