Why You Need to Diversify Your Investment Portfolio
Smart investors diversify their portfolios to protect themselves from risk and maximize their long-term gains.
Consider this scenario:
You’re a proud owner of one of the better sedans money can buy. Driving around on city streets and a highway is so smooth and comfortable you forget you’re even in your car.
But, one day you’re returning home from vacation. All highways are blocked, so an emergency situation forces you to drive off-road.
Now, your smooth ride becomes rough and uncomfortable. You hit big potholes that cause the bottom of your car to hit the dirt roads with a loud “Bang!”
If you were an SUV owner, you’d have no problem navigating this more treacherous terrain safely until you get home. And that SUV handles city and highway driving with ease too.
Having a Diversified Portfolio Gives You Safety & Comfort Like an All-Purpose SUV
Just like the super-versatile SUV, you need a diversified investment portfolio that withstands unpredictable market changes. When things go well in one area of the market (like smooth roads) you can feel tempted to allocate your portfolio exclusively for it.
But then those conditions inevitably change. Your high-performing stocks suddenly become the worst possible picks.
And then returns elsewhere in the market skyrocket. But you don’t have any capital to allocate to those areas.
One common solution is to shift strategies when market conditions change.
It makes sense – simply change your allocations when the market changes. But it’s extremely difficult to execute. It’s like keeping two cars in your garage when you need just a single vehicle. You pay double the insurance, registration, and upkeep.
Or You Could Reduce Your Risk & Keep Things Simple with a Diversified Portfolio
Your portfolio could include global emerging markets and domestic stocks. Right now, emerging markets aren’t performing well. But domestics are at all-time highs.
So by diversifying, some part of your portfolio should be performing well at any given time. But even a diverse portfolio isn’t immune to risk. For example, the crash of 2008-2009 severely hurt almost every stock imaginable.
With a diversified portfolio, you have a vehicle in the garage that performs well in all kinds of weather, on all roads, and with great fuel efficiency. If you make concentrated bets in certain sectors, like investors in tech stocks did just prior to the 2001 Dotcom Bubble, you can win big if you time it right. But, you can also lose everything, and you may not recover your losses for decades.
You can never know exactly which markets will outperform in any year. And big gains and losses will happen in the future. Diversification makes your outcomes more consistent, giving you an investment vehicle that makes rough rides more comfortable.