We’ve all heard the popular saying, “don’t put all your eggs in one basket”, right? Well, it applies to stock investing too.
Diversifying is so important in creating long-term wealth MyWallSt made it one of our 6 Golden Rules for investing success. Diversification is one of the most important steps in reaching financial freedom as it helps minimize risk.
Check out our video on the topic.
So what does diversification mean for investors?
In the investing world, diversification is an investing technique that helps reduce risk by holding stocks from a wide range of different categories. By diversifying, you can minimize risk which will likely help you maximize your stock returns by investing in different stocks that are likely to react differently to the same event or market condition.
Steps to diversifying your portfolio
Invest in companies with different market cap sizes. These categories are broken down into small, medium, or large-cap stocks.
- While buying shares in large companies can offer stable, consistent gains, they might not be able to offer huge growth. Large cap stocks also help your portfolio survive volatility because these well-established businesses’ share price does not usually fall dramatically.
- Medium cap stocks strike a nice balance between offering the potential for massive returns and helping investors feel confident as these companies are on their way to becoming established businesses.
- Picking up some small cap stocks is also an option as these investment types offer the best chance of outsized growth, but they also carry a lot more risk. This is why collecting a basket of stocks of different sizes is vital as it can help offset any risk that the smaller companies hold.
Invest in different industries
Investors also need to think about investing in varying industries to avoid risk.
You can diversify your portfolio by investing in different industries, including technology, retail, healthcare, entertainment, food, energy, manufacturing, and many more.
Picking up stocks in different regions
- Another great way to strengthen your portfolio is by investing in stocks from multiple countries, as different markets tend to perform well at different times.
- Thanks to the popularity and power of the U.S. stock market, investors can gain exposure to international companies that are listed on Wall Street.
- Some great examples of companies from overseas include MercadoLibre (NASDAQ: MELI) which is a company founded in Argentina, Spotify (NYSE: SPOT) a music streaming leader headquartered in Sweden, and Tencent (NYSE: TME) the Spotify of China!
Diversify your investment style
- Striking a balance between buying individual stocks and exchange-traded funds (ETFs) is wise.
- While individual stocks offer the potential for higher gains, ETFs offer instant diversification as they contain holdings in many different companies.
- A single ETF can give exposure to a group of equities based on region, industry, size, and any number of other classifications. You can also buy ETFs that track the market’s main index, such as the S&P 500 (NYSEARCA: VOO).
What are the risks associated with not diversifying?
To really understand the advantages of diversification, we have to look at the possible negative outcomes if you were to only buy shares in companies in the same country, industry, size, or asset type.
For example, say you invested a majority of your cash into U.S.-listed Chinese stocks in 2020. In this scenario, your stocks would have been severely affected by the government intervention that took place this year. Over the past few months, Chinese officials have taken a tough stance on companies in their region that are listed on foreign exchanges. If an investor did not have holdings from other countries, their portfolio would have been severely in the red and might have led to the thing long-term investors should dread the most — panic selling.
Similarly, if you held too many travel and airline stocks pre-pandemic, you would have been severely in the red when COVID-19 forced lockdowns upon the world. To counterbalance this, if you had invested in different industries such as e-commerce or streaming services, which both blossomed during the pandemic, your investments would have been less affected.
Should I diversify my portfolio?
There are not many guarantees on the stock market, but you can bet that over a prolonged period of time, some of your stocks will fall in value. Volatility will always play a role in the investing game, so owning a bunch of diversified stocks will help offset massive losses and lead you to financial freedom.
Read the other articles in our Diversify series here;
Financial Writer at MyWallSt
Nicole's favorite stock is Etsy because she loves its original and handmade items. She believes people are going to stop buying mass-produced items and start purchasing ‘one of a kind’ fashions and furnishings. In a world of sameness, Etsy has the advantage.