If there’s one solution that keeps jumping out to you in how to manage away a lot of the risks in investing, it’s diversification.
Diversification means ‘to spread it around’, that is, to spread your money over several, not one, investments. Like not putting all your eggs in one basket, for if you drop the basket, chances are they will all break. Likewise, if you sink all your money into one stock and if that stock plummets in value, you could lose all of your money.
Generally, a diversified investment portfolio has different baskets of investments so to speak. Each basket could be likened to an asset group (like stocks or bonds or futures). The next step is to further diversify within that asset group. Hence buying stock means buying stocks of various sectors, or buying unit trust means buying more than one kind of unit trust fund (there are income funds, growth funds, bond funds etc.)
The strategy is to mix high-risk and low-risk investment vehicles and to allocate them wisely among your baskets and within each basket. Why? So that you have a better chance of winning within an asset class and among the asset groups. Imagine the unfortunate circumstance of having all your savings tied up in the stock market and needing immediate cash but the stock market remains stubbornly bearish. This is not diversifying among asset groups. Or putting all your money into property shares only to have real estate sink into the doldrums while other sectors are booming. This is not diversifying within an asset class.
But with diversification, if one of your assets takes a nosedive, you have many alternate assets to fall back on. If you diversify smartly, the losses in the non-performing investments will be easily absorbed in the gains of the better performing ones. Your investment risks are minimised while your average rates of return are maximised.
However avoid over-diversification. While you don’t want to store all your eggs in one basket, you also don’t want to scatter your eggs among so many baskets that you find it difficult to monitor your investments. Furthermore when you are over-diversified, your investments start to counter-balance each other so that your rate of returns is actually diminishing.