Why Is It Important to Diversify Your Investments?

Why Is It Important to Diversify Your Investments?

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Investing is more of an art than an impulse reaction, and it’s worth learning about investment strategies to reduce your losses and maximize your long-term gains. When starting out in your journey as an investor, it’s essential that you ask questions like “Why is it important to diversify your investments?” and develop a well-diversified portfolio that will help you achieve your financial goals.

Why Diversify?

While you might be keen to invest in a fast-growing startup or support your favorite company, the reality of the game is that the stock market is volatile and things can change at any time. When you talk with an investment advisor representitive about why it is important to diversify your investments, he or she will probably talk to you about risk mitigation and boosting your overall returns.

Just as they say “don’t put all of your eggs in one basket,” don’t buy all of your securities with one company or in only one industry sector. By diversifying your investment portfolio, you should be able to weather the ups and downs of the stock market with ease.

What Does A Well-Diversified Portfolio Look Like?

In the investment industry, a well-diversified portfolio is defined as a portfolio that includes a varied range of securities so that the influence of each security is small. This diversity acts as a buffer against sudden drops in a single security and results in an overall risk profile that is similar to that of the systematic risk of the market in general.

Diversify Your Sectors

Once you’ve worked out why it is important to diversify your investments, you will want to select several sectors and companies to spread your assets across. Sectors include:

  1. Technology
  2. Real estate
  3. Financials
  4. Utilities
  5. Consumer Discretionaries (including retail)
  6. Consumer Staples (including food and beverages)
  7. Energy
  8. Healthcare
  9. Industrials
  10. Telecom
  11. Materials

Within each of these sectors, you can invest in specific companies or consider exchange-traded funds (ETFs). Like stocks, ETFs have a dollar value and can be bought and sold throughout the day. The difference with these securities is that they represent a predetermined portfolio of investment holdings from a given sector and rise and fall with their corresponding market index.

Diversify Your Securities

In addition to choosing more than one sector, once you understand why it is important to diversify your investments, you will also need to select more than one security within each sector—whether or not you’re dealing in ETFs. A good rule of thumb is to purchase a maximum of 20–30 different securities. That way, you will be mitigating the risks associated with any particular company but won’t miss out on a rapid rise in the value of any one of your securities.

Diversify Your Investment Types

When thinking about why it is important to diversify your investments, consider investing in different kinds of investment opportunities as part of your well-diversified portfolio. Securities are one type of investment opportunity (as are ETFs), but you can also invest in:

  • Real Estate Investment Trusts (REITs)
  • Commodities
  • Index or bond (fixed-term) funds

For investors who are averse to risk, index and fixed-term investments provide a worry-free way to make some passive income over time and typically have the lowest management fees of all investment types.

Investment Strategies That Can Maximize Your Returns

Once you’ve realized why it is important to diversify your investments, you can often improve your investment earnings with these tried-and-true strategies.

  • Buying and holding
  • Dollar-cost averaging

Buying and Holding

Reflecting an evidence-based investment style—the philosophy we follow at ML&R Wealth Management—a buying and holding strategy means maintaining more or less the same portfolio over the long term.

People who choose a buying and holding approach often take the position of activists. They seek to influence a company’s management decisions and share their gains and losses with the company. However, as these investors understand why it is important to diversify their investments, they will still choose up to 20 different securities to complete their ultimate investment portfolio.

Dollar-Cost Averaging

A contrasting approach to buying and holding is dollar-cost averaging, which involves dividing your total amount of capital into parts and determining how many securities to buy each time according to their price. For example, you would buy more securities when prices are low and fewer securities when prices are high. This kind of approach requires an active management approach and helps to smooth out the short-term volatility of the market.

Other Factors to Consider When Building a Well-Diversified Portfolio

A light bulb inside a chalk thought bubble on a blackboard.

In addition to understanding why it is important to diversify your investments, you also need to answer the question “What is important to me as an investor?” For some, a need for short-term gains determines the strategy used and the securities chosen for their portfolio. This means choosing the securities with the quickest growth or the most stable performance over time. For other investors, putting their money into industries they care about outweighs the net loss or gain of their securities over time.

While it might not seem like the soundest strategy for increasing wealth quickly, investing in goods and services that you actually use yourself can add a personal connection to your portfolio and motivate you to follow developments in the company. When you understand why it’s important to diversify your investments, you can personalize your strategy by choosing a few securities in other sectors and regions that are in line with your values.

Reach Your Financial Goals Sooner with ML&R Wealth Management LLC

All things considered, the best way to ensure a well-diversified portfolio and maximize your long-term wealth is to consult a qualified investment advisor who uses academic-based investment strategies.

At ML&R Wealth Management, we have more than 20 years of experience in answering questions like “Why is it important to diversify your investments?” and have helped numerous individuals, families, corporations, and nonprofits to achieve their financial goals in ways that matter to them.

Explore our services to find out how we can assist you and contact our team to schedule your complimentary consultation today.

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