The Importance of Portfolio Diversification in Your Financial Planning

Portfolio diversification serves an important role when it comes to financial planning. A properly diversified portfolio can lower your risk incidence and offer you better returns over time. However, too much diversification can be damaging to your overall portfolio and the attainment of financial goals. Hence, it is advised that you consult a financial advisor to identify the right opportunities to design an optimized diversified portfolio.

Let’s discuss five important points to know when you decide to invest in a diversified portfolio:

  1. Diversification distributes risk, it does not eliminate it
  2. A lot of investors seem to operate under the misconception that if they diversify their portfolio, it will reduce their risk to negligible levels. That is not true. One needs to understand that there will always be some amount of risk involved in your investments. By picking different assets and stocks in a bid to diversify your portfolio, you spread the risk across different industries. For example, if you hold stocks in companies belonging to the pharmaceuticals, technology, or food industry, you’d have made your portfolio impervious to market forces to a great extent. It is quite unlikely that all industries react to market fluctuations in the same manner. So, for instance, if your stocks in the pharma industry take a dip, you’d be able to cover those losses from your stocks in the food industry or vice versa. A financial advisor can help you diversify your portfolio and how you stand to benefit from the investments you’ve made.

  3. Over diversification is not ideal in the long run
  4. As a general rule, moderation should be practiced in every sphere of life, and it’s no different when it comes to financial planning. Typically, financial advisors would advise you to diversify your portfolio and educate you on its importance, however, they’d also caution you against the dangers of over-diversification. If you over diversify your portfolio, you run the risk of exposing yourself to additional risks that may backfire in the long run. Not to mention keeping one informed with so many investments can also be challenging. Some investments require you to be alert and monitor them carefully. If you’ve got your hands full with multiple investments that require your attention, you may end up missing out on crucial opportunities due to not being able to identify said opportunities in time. So, while diversification is essential to protect your portfolio, over-diversification is not. Generally, a financial advisor would suggest that on average an investor should keep at least 20 investments on their portfolio and not more than 30 as a rule of thumb.

  5. Choose the right asset classes and ensure that you diversify regularly
  6. The simplest explanation of diversification is that one spreads their money across different industries to minimize their risk. A lot of investors carry out this exercise with great zeal but tend to forget that diversification is not limited to industries alone. One must take care to diversify their portfolio across different asset classes as well. For example, choosing stocks from three different industries will only partially lower the incidence of risk, you must also seek to invest in different asset classes, such as bonds, equity, cash and cash equivalents, exchange-traded funds (EFTs), etc. Additionally, you can also consider investing in small, mid, and large-cap stocks. Doing so would enable you to fully exploit the benefits of diversification. A financial advisor can assist you with investing your money in varied asset classes along with the need to diversify your portfolio in regular intervals. Diversification is not a one-off activity, one needs to revisit it from time to time to tweak your portfolio as your financial goals and needs may evolve with time.

  7. An optimally diversified portfolio shows a wide array of performances
  8. Though the purpose of diversification is to lower your risk to the minimum possible degree and boost your returns to the maximum, it is not feasible that your portfolio would always yield profits. The markets are dynamic, changeable, and uncertain due to which most investments tend to fluctuate between losses and profits. An indicator of an optimally diversified portfolio is the reaction of your investments to market forces. If the reaction to market fluctuations tends to vary across a wide spectrum, it shows that your portfolio is diversified effectively. However, if all your investments react similarly, then diversification is not an effective one. While the ultimate goal of diversification is to generate profit, inconsistency in performance generally tends to point toward ineffective diversification.

  9. Don’t neglect investing in international investment products
  10. One may believe that in this age of globalization diversifying in domestic stocks is as good as foreign stocks, one should not disregard the many advantages of global exposure on your portfolio. Apart from offering more growth opportunities, foreign markets are not exposed to the vagaries of domestic markets. Though, this does not mean that global diversification is immune from threats. A financial advisor can guide you on how to stay up to date with changes taking place in currency dynamics, foreign policies, and political, economic, and social changes in the country where you’ve invested in as well as your own. Moreover, this kind of diversification may only be suited to investors having a high net worth due to it needing a greater degree of flexibility and liquidity. This kind of diversification may not be ideal for all individuals and may pose a risk to some portfolios. Herein, a financial advisor can step in to help you assess if you should invest in foreign markets or not.

To summarize

It’s no secret that diversification is necessary if you want to bring in steady profits however you should not ignore the complexity diversification poses. The majority of investors are prudent enough to understand not to put all their eggs in one basket, however not many can put it into practice. This is why it is highly recommended that one reaches out to a competent financial advisor who can advise them where and when to invest.

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