Diversification? Not magic, but a good idea! - May 31, 2015

Diversification? Not magic, but a good idea!

We are hearing more and more about diversification and sometimes it might seem that it is a magic word in investment. It is not, however, magic, but a very effective and deliberate way of investing our money without taking too much risk but still realising great earnings. How? Let us explain simply!

If an investor only relies on one asset, expecting the asset to rise greatly, they can be right (or have luck), but one can always make miscalculations, and the market can sometimes surprise the investor. In that case, instead of nice returns, the stockholder can lose significant amount of money. To understand the risks better: it is not rare that an asset loses more than half of its value in one year.

Or to put it a bit differently, as the proverb goes: “Don’t put all your eggs in one basket”, because if you drop that one basket, you lose all your eggs. Some people are willing to take that risk, but others want a safer solution that is still profitable.

That is the point when diversification comes into the picture. To explain it simply, it means that an investor puts his or her eggs in several baskets, or to stick to the world of business: investing in several assets. This way, in case of lower performing assets, the others can still do well, and because of this “built-in” compensation, in total, there is still a return.

While this is the main idea behind diversification, there are several different ways to diversify one’s portfolio in reality. Sometimes the assets are chosen randomly, other times they are diversified by industry or company size. Many investors believe that geographical diversification is also rewarding, since some territories perform better than others, and emerging markets can perform really great sometimes.

There is another interesting question: how much diversification is good? For that, there is no clear answer. Even a portfolio of 10 assets can be well diversified, but usually the higher number the better. What is really important here, is that an over diversified portfolio can really lower the risks, but can also diminish the earnings.

Then again: there is no good investment without risk but a stockholder can still do his or her best, to invest in a clever way, minimize dangers and still earn returns.

Disclaimer: Innovative Securities’ Profit Max has a highly diversified portfolio, containing more than 120 instruments in more than 20 markets. Investing in this portfolio can lower the risks, while still grant great returns to our partners: in the last 5 years, our portfolio performed better than the S&P500 Index.