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Sep 23, 2021 PropStream

Investing Diversification: What Is It and Why Is It Important?

Investment diversification is a strategy where an individual or organization segments resources. Spreading out your resources is a great way to help limit risk and maximize profits. When you diversify your investments, you divide your money into stocks, companies, bonds, mutual funds, or other ventures that you believe will generate profits.

Whether you prefer to invest your own assets or trust an experienced financial analyst, diversifying your investments can help yield fruitful, long-term returns. Consult the below strategies for more information on the tactics and value behind diversifying your investments.

The Basics of Diversification in Investing

Every investment carries an inherent risk. If stocks fall, markets turn, or businesses go bankrupt, you might lose some, or even all, of your original investment. If you invested all of your money in a single industry, business, or other assets, you could suffer large financial losses.

To avoid falling victim to this risk, many financial investors preach the importance of diversification.

Diversifying your investments helps to keep you safe from the volatility of a single market. When you diversify your investments, you place money in several different industries and investment types at once. Even if one market falls or a certain investment type loses value, your other investments are safe.

As you diversify your portfolio, you’ll also need to guard against over-diversification. If you allocate money into too many different markets, you won’t have the time or resources to maintain all of your investments at once. Try to limit yourself to a comfortable portfolio, where you have enough time to monitor the progress of each investment.

Once you reach around 20-30 total investments, your portfolio is sufficiently diversified. Instead of making further investments, turn your attention toward maximizing your current assets.

How to Diversify Your Portfolio

With a diversified portfolio — where you make investments across multiple markets — you set yourself up for returns over time. At the same time, you’ll help protect yourself against issues with a specific market, business, or investment type. As your financial portfolio matures and you add investments, you’ll begin to identify the companies, markets, and investment types that work best for you. 

Diversified Portfolio Example

With the right investments, you can diversify your assets and remain safe from sudden financial risk. When diversifying your portfolio, consider the following investment types:

  • Stocks
  • Bonds
  • Mutual funds
  • Savings accounts
  • Exchange-traded funds (ETFs)
  • Certificates of deposit
  • Index funds
  • Options

Of the above investment types, many investors prefer real estate investments for their passive income, tax benefits, and regular cash flow. Before investing, learn more about investment types and the impact that each can have on your portfolio.

You can quickly familiarize yourself with proper real estate diversification methods with free financial education resources. Some platforms include property search and targeted lead features to help you fulfill real estate investments without hassle.

The Importance of Diversification

Diversification is an essential step for anyone serious about improving their financial portfolio. Through diversification, you’ll be able to reduce the risk of financial loss and improve the overall strength of your portfolio.

Diversification also allows you to maximize both short and long-term financial gains. Different investment types yield returns at different times. When you diversify your financial portfolio, you’re setting yourself up to receive steady cash flow from these investments. For example, real estate investments can generate regular returns when tenants contribute to rent or when you’ve flipped a home for profit.

By contrast, stocks and bonds can represent a longer-term investment. After your stocks, bonds, or other long-term investments accrue value, you can sell them for far more than their original purchase price.

Different Types of Risks

Diversification helps you avoid many risks during the investment process, but it can’t help you avoid them entirely. Depending on market activity, stock price, and a variety of other factors, your investments could yield returns or losses over time.

If a risk can be avoided through diversification, that risk is often called “diversifiable.” Risks that can affect even diversified financial portfolios are classified as “undiversifiable.”

Undiversifiable Risks

Undiversifiable risks may arise no matter the strength of your portfolio. These risks can affect entire industries, currency value, or other factors that determine the success of your investments. Because of the large-scale nature of undiversifiable risks, they are sometimes known as “systematic” or “market” risks to investors.

Undiversifiable risks can include the following issues:

  • Inflation rates
  • War or civil conflicts
  • Resource limitations
  • New market competition
  • Political uncertainty
  • Corporate fraud

Undiversifiable risks cannot be alleviated through diversification. Instead, they are simply risks that any investor accepts when they begin the investment process.

Diversifiable Risks

Unlike undiversifiable risks, diversifiable risks can be reduced when you diversify your portfolio. Also known as “unsystematic risks,” diversifiable risks generally affect a single organization or investment type at once.

Diversifiable risks can sometimes include the following issues:

  • Employee strikes
  • Natural disasters
  • Product recalls
  • Internal company litigation

As long as your portfolio includes a healthy number of investments and industries, you'll be safer from larger-scale loss caused by diversifiable risks.

The information contained in this article is provided for educational and informational purposes only, and should not be construed as legal, investment, or financial advice. No recipients of content from this site should act or refrain from acting on the basis of any content included in the site without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue.

Published by PropStream September 23, 2021