Why diversification is important (and how to do it)Investing knowledge
You’ve probably heard the phrase, “don’t put all your eggs in one basket.” This is particularly important when it comes to investing. But why, exactly, should you diversify your portfolio? We’ll answer that in this article. Read on!
- A diversified portfolio helps reduce the overall risk of your investments.
- How to diversify? Choose different asset classes, from different sectors and industries, as well as different regions of the world.
- ETFs are a good way to get broad exposure and diversification within one investment.
Definition of diversification
Diversification is a strategy whereby you invest in different assets from several different sectors. It helps spread your risk, so if one asset or industry falls, it’s balanced out with your other investments.
Limit your exposure to risks
Whenever you invest, you’re taking on a certain level of risk. Indeed, assets can be volatile and don’t always guarantee returns. A diversified portfolio, therefore, helps dilute the risk you’re exposing yourself to.
Let’s take an example. It’s 2019 and you decide to invest in shares of Air France and Lufthansa because you think these two airlines have a bright future ahead. Little did we know that bad luck was around the corner. The Covid-19 crisis soon hit and grounded most air traffic. The value of your airline shares loses almost two-thirds of their value in a matter of months.
However, if you’d diversified your portfolio with an investment in pharmaceutical companies, like Pfizer, or shares in tech companies like Apple or Facebook, then you would have compensated for this loss thanks to these companies booming during the pandemic.
Striking a balance
Some investors argue that buying too many assets isn’t a good idea because every trade costs extra transaction fees and brokerage costs. In the past, high fees could eat into your profits, especially if you’re starting out with a small amount.
Good news: thanks to platforms like BUX Zero, commissions are eliminated which favours small investments. Now you can diversify your portfolio with various assets without worrying about the additional costs.
Different ways to diversify your portfolio
There are three main ways to diversify your portfolio and broaden your investment profile: by asset class, by sector and by geographic region.
On BUX Zero, you can search for assets based on these parameters to find the ones that suit you.
By asset class
The financial markets offer various different asset classes: stocks, ETFs, currencies, cryptocurrencies, commodities, etc. There are many asset classes and you should learn the risk/reward ratio of each before you start.
And even as you do diversify your investments, never risk money you can’t afford to lose, and set yourself a maximum level of loss.
Beyond the asset class, you can invest in different industries or sectors. For example: technology, real estate, automotive, healthcare, energy and travel. Some sectors are more stable while others have better growth potential.
In recent years, the tech stocks have seen the biggest growth, led by Facebook, Netflix, Google and Microsoft. But that doesn’t mean the next ten years will be the same!
For example, one sector that often seems to thrive no matter what is going on in the world is luxury goods. You can get exposure to this sector with French stocks like LVMH, Hermès or Dior. Learning more about different sectors will help strengthen your overall portfolio.
Additionally, you can spread your investments between different size companies, by checking their market capitalization. This allows you to invest in smaller companies that have potential to grow much larger, while maintaining some stability with bigger companies.
By geographic area
Although trade now flows freely around the world, different regions have different levels of growth. Additionally, some countries face different economic challenges compared to others and different financial policies. While some crises are global, like the 2008 banking meltdown, others are more regional. For example, the 2011 eurozone crisis didn’t affect Wall Street.
Therefore, an ideal portfolio is an international portfolio. Again, we can break these down into three main categories.
- Established markets of developed countries, where the economic and financial situation is stable. These are generally less risky investments.
- The emerging markets of developing countries, which are less stable and more risky, but with substantial room for improvement and growth.
- Frontier markets of underdeveloped countries, but showing positive signs of development. They are sometimes called pre-emerging markets.
Warning: before increasing your investments in foreign regions, you must be aware of the risks associated with the exchange rate between currencies, which can eat away at your profits. Also make sure to monitor the political situation in each country, especially in the event of a change of government, for example.
ETFs: kings of diversification
Exchange-traded funds (ETFs) are a basket of assets. They are often diversified by their very nature. They allow you to spread your investments over the tens, hundreds or thousands of securities in one simple basket, often with a small starting amount. This broad exposure makes ETFs especially suitable for long-term investors.
In order to obtain a diversified portfolio, you must therefore:
- Determine your risk tolerance.
- Decide how you want to allocate between different asset classes.
- Choose your assets, for example according to sectors or geographic areas. If you’re still not sure, opt for the most diversified ETFs.
- Manage your portfolio by rebalancing it regularly: add a percentage of an asset class that is growing well by selling another less performing one, for example.
You now have the essential keys to building a diversified portfolio. These skills will help you manage your investments calmly and without panic.
All views, opinions, and analyses in this article should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.