Diversification is a fundamental strategy that allows you to invest your money in multiple companies’ stocks simultaneously, reducing the immediate risk associated with any individual company’s actions or profit potential.
To illustrate the concept of diversification and its alignment with your risk tolerance, let’s compare investing in stocks of multiple companies versus investing in just one company.
You have the option to distribute your investments among the top 100 companies in the market or focus on 5 companies that are frequently discussed in the news.
I recommend the former approach, as it provides exposure across a broader range of industries and creates a diversified portfolio.
By avoiding over-concentration in a few stocks and opting for a well-diversified portfolio, you can minimize the impact on your returns if one company underperforms. Conversely, if one stock performs exceptionally well, your broadly diversified portfolio may experience a slight lag.
Overall, this strategy aims to achieve average annual expected returns while reducing volatility, leading to a more stable long-term growth trajectory.
Although returns cannot be guaranteed, and past performance is not indicative of future results, investing your money in stocks within a diversified portfolio tends to perform well over time.
Diversification and Risk Management #
Investing in individual stocks comes with inherent risks and uncertainties that can impact your investment portfolio.
To begin with, investing in a single stock exposes you to diversifiable risk, which arises from the uncertainty associated with owning a specific stock or being concentrated in a particular industry.
To mitigate this risk, investors can opt for a diversified approach by investing in a wide range of stocks, sectors, and industries. By spreading investments across different assets, one can avoid the pitfalls of relying on a single stock or industry.
This principle also applies to alternative investment options, which offer the opportunity to diversify across multiple assets instead of relying on a single investment.
While holding a limited number of stocks or sectors may potentially yield higher returns for investors who are comfortable with risk, it can also pose significant challenges for less-experienced individuals (and even professionals), as the added risk can jeopardize the overall performance of their investment portfolio.