When people set out to make money by investing in stocks, they try to avoid risk in as many ways as possible. For this, the best way is to diversify their portfolio in as many ways as possible. However, diversifying your portfolio is not as easy as it seems to be. Nevertheless, for any investor diversification of their portfolios is easy if they are ready to follow some basic rules that will keep big losses at bay.

Diversification: What It Is

For a person that invests money in stocks, it is important to understand what diversifying a portfolio means. Instead of investing all the money that is set aside into a single stock, it is better for the investor to place their capital in stocks belonging to different industry sectors. When this is done, the risk of losing because a specific industry is not doing well can be overcome with stocks that are performing well and belonging to other industry sectors. Though diversification is not a complete insulation against losses, it has its advantages in these types of situations and has the potential to minimize the investors’ losses while simultaneously allowing the investment to grow larger.

Risks: Different Types

As an investor, if you are thinking of investing in stocks or bonds or any other financial instruments, it is important to bear in mind that there is a certain amount of inherent risk that is involved. The first step in reducing risk is to understand the basic nature of these risks. That by itself can help to reduce the amount of losses or even bring them down to zero. Diversifiable and non-diversifiable are two classifications of risks. Non-diversifiable risks are those factors that are common for any type of industry. Examples are political inflation, cost of living, etc. These risks cannot be avoided and generally should be considered in relation to other factors and worked out as to how it would affect the value of the portfolio.

Diversifiable risk, on the other hand, is dependent on a specific industry or country or a company. For investors, to avoid encountering diversifiable risks, that would undermine their stocks, it is a good idea to distribute the assets in the portfolio in such a manner that the reactions are all different to the same situation at hand. This strategy will help to keep the investment safe.

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Go for New Strategies

For investors it is important to recognize the fact that their money should be spread out in different places to keep losses to a minimum. It does not pay to keep all the stocks huddled into one place as this will only magnify the losses. They should not invest all the money in the stocks of a single company and, simultaneously, it is also important not to invest in similar companies or ones that are strongly correlated to one another.

Investing in Opposites Helps

Just like in love, opposites attract. In this context it means that for investors, it is wise to invest in asset classes that move in opposite directions. A typical example of this would be to invest in stocks and bonds whose values move in opposite directions almost on a daily basis. These different asset classes do not react in the same manner to adverse market events that may occur. This strategy helps to even off any decrease in value that occurs when one asset class performs badly. Over the passage of time, these opposite swings will keep the asset value even and more shielded to sway that may occur in the market. As a thumb rule, every investor that wants to start investing in the market should include bonds in the portfolio which would work to even out any losses that would occur do to devaluation of stocks. It is also a wise idea for the investors to make some investments in real estate and other alternative assets.

No Guarantees Whatsoever

All said and done, a beginner investor in the market should understand that any diversification of a portfolio does not guarantee a successful investment. However, this strategy has been seen to increase the chances that the investor will get positive returns over a period of time than if all the stocks were of a single company or in those companies belonging to a single industry. This would help the investor to reduce price volatility. All said and done, the stock market is a place where a basic amount of risk persists even if all the stocks in the portfolio were correctly diversified. Practically, it has been found out that adding about 20 stocks to the portfolio reduces the risk to about 20 percent.

Over diversification is also not a good idea as it has the capacity to undo all the good effects that diversification would bring about. Any addition from 20 to 1000 stocks in the portfolio helped to reduce the risk by only 0.8 percent. That is, beyond a certain point, there is no further benefit to the portfolio by further diversification. Therefore, maintaining a balance is important.

This is a situation that is often encountered by big time investors. Firstly, investing in a very wide portfolio would create a larger amount of confusion for the investor. A messy portfolio would end up creating more losses than the gains that it is supposed to bring. The benefits the diversification would bring about will simply be lost and all the investor would be left with is a mess.

Final Thoughts

It is compulsory for every investor to have their own unique trading plans to meet their financial goals. It has also been observed that those investors who make investments over a wide range of stocks always perform well (depending on the market conditions). Investors that invest heavily in a single direction often run into rough weather when compared to the others. Therefore, for any beginner investor, diversification should be given serious thought right in the very beginning and the investor should spend sufficient time learning about the benefits that it can bring about.