When you think you’ve found something good, it’s tempting to just throw everything you have into it. It’s bound to work out well, right? We’re not so sure.
It might pay off for you here and there, but if it doesn’t, then you’ll feel the wrath of your risky investment and potentially lose everything. That’s the trouble of putting all your eggs into one basket – you leave no room for human error. You or your investment advisor may have gotten it wrong. This is highly likely if you consider how fund managers, on average, are being crushed by the market. You not only take on a considerable amount of risk, but also limit your portfolio's growth potential by not being diversified.
Sin #5: Wrath
Wrath is a strong word. But, it’s necessary to use it if we’re to understand what ignoring diversification could bring.
Imagine you are on the brink of retirement, with only one or two big investments that you had planned would carry you over. Next thing you know, the market’s getting rocky due to the country’s precarious economic state, the company you invested in is discovered for some scandal and stocks drop, or, out of the blue, your investment rapidly devalues. It can happen so quickly, which is why the age old saying of “don’t put all your eggs in one basket,” is so pertinent to investing. Diversification is key.
It’s tempting to commit to a seemingly great opportunity with a large investment, because if it is successful then your return on investment (ROI) will be so much larger. But, the only certainty in investment is that nothing is certain. Diversification minimises risks by spreading your investment over a wider field of opportunity. Whether we’re certain about an investment or not, it doesn’t change that the stock market is volatile and can change in an instant. Diversification minimises potential loss by spreading your money across various various asset classes, industries and regions.
The How-To of Diversification
The idea is as simple as not investing in a single stock or sector, but rather spreading your investment over different stocks, properties, bonds and markets. Yet performing this idea is not as simple as it sounds. It’s all about understanding value investing.
Value investing is seeking out investment opportunities that you believe the market has undervalued. Its core lies in the belief that market volatility is generally caused by overreactions to good and bad news, meaning that if you stick with diversified long-term investments, your investments will most likely pay off in the long run. For instance, the Little Acorns portfolio is made up of diversified value stocks and achieved 16.1% returns, beating all major global markets in the past year.
You’ll hear lots of advice telling you to look into stock mutual funds, bonds and a combination of these. While the advice is often sound, it’s the process behind choosing your investments that really matters when diversifying.
Research and Reaction
Diversification doesn’t mean not doing your research. You still need to decide what level of risk you’re investing for, what your goals are (short-term or long-term, or a combination) and then analyse which stocks, properties or markets match your portfolio. When you’ve selected which sectors you’re interested in, divide them up between the investment risk according to market cap, industry and location. The difference of value investing is that now you can have high risks investment alongside low risk investments, and spread your specific risk-level investments over multiple sectors. You have more to watch, but you’re limiting your liabilities, which means that you have more surety in a volatile market.
What’s even better about diversification is that when the market rises, you are in a great position to take advantage of the stocks that are performing best and hold back on those that still have growth potential. It allows you to have a calmer hand when the market gets a high fever and begins to move rapidly. You can have patience for the full potential of your stocks, because your income is not dependant on a single investment.
Diversification is the key to value investing, because it allows you to embrace patience and be comfortable with your investment decisions. Don’t let wrath overcome you, but rather diversify and limit your liabilities for stable, but great, returns.
To catch up on all of the seven deadly sins of multi-asset investing, click here.