Diversification to Reduce Risk

When you first start investing, you may be scared that you will lose money. Most people are. However, in order to be a successful investor, you have to remove your emotions from the mix. Some people do this by investing long term and reminding themselves that short term movements do not matter. Others only invest a small amount in order to keep their wits about them. The fear of losing money is nothing unusual. It is often referred to as the risk of losing money. Putting your money at risk is never easy especially when you have fear that you will lose that money. Well, there are a few ways to reduce or minimize the risk of losing money.

What is Risk?

Like I mentioned before, risk is the chance that something will happen, usually an undesired outcome. If I ride a bike, there is a risk that I will fall off. If I eat raw fish, there is a risk that I will get food poisoning. Should I never ride a bike or eat sashimi? Of course not. But there are ways that I can mitigate or minimize the risk that something bad will happen. If I practice riding a bike with training wheels until I get comfortable, the chance that I will fall off my bike will reduce. If I eat at a reputable restaurant that sources its food from responsible supplier, the risk that I will get sick is lessened. When you are getting into investing you should be practicing before you jump into the market.

Diversification Reduces Risk

Diversification is the word that describes that old cliche, “Don’t put all of your eggs in one basket.” If you are carrying one basket with all of your eggs and it falls, you will be very sad that you no longer have eggs to sell to the grocer. But let’s say you held two baskets. If one falls, at least you have the other basket. I consider different asset classes for my baskets. There are many to choose from; stocks, bonds, futures, options, foreign exchange and real estate to name a few. Some stick with one asset class but spread their investing in different style investing. You could buy some American companies and mix in some stocks from global businesses. Maybe you want to mix small companies with a low market capitalization with bigger companies that have higher market caps. You could invest in companies with different types of business or mix service businesses with manufacturing. The way that you decide to diversify is really up to you, but some diversification is typically good for your portfolio.

Too Much of a Good Thing

Although diversification is usually good for the most part, there is a point where too much diversification can hurt. If you are trying to pay attention to stocks and options and futures, you may have a hard time keeping up with the factors that influence the movements of each. For example, economics and government policies may have an impact on futures while company decisions may impact your stock more. Which one are you keeping up with? Do you have the time to pay attention to both? If investing is not your full time job then probably not. I always say it’s best to diversify with focus. If you are comfortable with stocks, stick with them and find ways to diversify within stocks. If you are better with real estate, focus your efforts and diversify with different types of real estate. Just remember, jack of all trades is a master of none. Make sure you are honing in on what you do best.

Do you diversify in your portfolio? Are you in stocks only? How do you invest?

Tagged as: bonds, diversify, foreign exchange, futures, mitigate risk, mutual funds, options, risk, stocks