Importance of Diversification

Have you ever heard of the term "don't put all your eggs in one basket?". Well, this is especially true for investing and is the essence of diversification. What this means is that you should invest in many different types of assets and investments instead of just one. This is because different types of investments react differently to certain events, so if one of your investments goes sour, you will stil have others to back you up. In the long run, diversification reduces risk and research has shown that investors with a diverse investment portfolio consistently see higher returns than people with only one type of investment.

When diversifying your investments, it is best to have them as uncorrelated as possible. This is because if you diversify your portfolio by investing in two different companies, such as coal and gas mining, it would still pose a risk. This is because both companies are invovled in natural resources, and in the unlikely event that for e.g. a law is passed that limits the mining of natural resources, both companies could descrease in value and ultimately descrease the value of your investment. That is why you should invest in many different types of industries and also different types of assets. Also, when looking to invest in different assets, try to find ones which don't tend to increase and decrease in price at the same time. This can also help to diversify your investments even further.

Also remember that diversifying your investments means that you are supposed to reduce the amount invested in each type of asset. If you invest $1000 in investment A and then another $1000 into investment B, you are not lowering risk at all. To diversify, the amount invested into invesment A needs to be split and than invested into investment B, for e.g. you take $500 from investment A and then place this into B, making both A and B hold $500.

Ultimately, diversified profiles could stilll potentially have smaller gains than undiversified profiles, but they will tend to have steadier results. Remember, diversifying doesn't eliminate risk, but certainly does decrease it. Watch the video below for more information.