Here at Super Network Financial Services, we cannot stress enough the importance of diversification in investment assets and asset classes. Unfortunately, this simple and essential risk reducing strategy isn’t often understood by new investors until it’s too late.
The Importance of Portfolio Diversification
Have you ever heard of the expression: “don’t have all of your eggs in one basket”? This is essentially what portfolio diversification is; you are spreading the risk across numerous investments and asset classes. Whilst you can never truly eliminate all risk from your portfolio, you can significantly reduce asset risk by building a well-diversified investment portfolio. Let’s have a look at how diversification works with some simple illustrative examples.
Let’s say you have $150,000 dollars to invest, but rather than invest this money across numerous shares or property (or any asset type), you decide to buy a single asset (called investment “A”). Now let’s say that over the next six months that particular investment (investment “A”) falls by 50% in value due to poor economic conditions.
This means that your initial investment of $150,000 is now worth $75,000.
This means that for this investment to recover to “breakeven”, the sale price of this investment needs to increase by 100%! Obviously, this is not a good scenario to be in and the overall drop in the portfolio value could have been avoided with diversification.
How to Diversify your Portfolio
With that initial investment of $150,000, you decided to purchase two investments instead of one (in equal proportions), called investment “A” and investment “B”. Again, over the next six months investment “A” falls by 50% in value due to poor economic conditions, however, the value of investment “B” remains unchanged as it’s unaffected by this particular economic change.
As you can see in the image above, the overall value of this portfolio has fallen less than if you were to have a single investment. In fact, your portfolio has only fallen by $37,500 or 25%, which is significantly less than the first example.
Holding two investments though isn’t really an adequate level of diversification. Let’s use the same example, but instead of only purchasing two investments, you decide to purchase four, called investments “A”, “B”, “C” and “D”; with “A” being the only investment falling 50% in value and “B”, “C” and “D” all remaining unchanged.
In this example, the value of your portfolio falls by $18,750 which is 12.5% of the initial portfolio investment value. As you can see, there is a pattern here. The more diversified a portfolio is, the less a single poor performing investment impacts the total portfolio value.
How much is enough diversification depends on you as an individual and your tolerance of risk? At Super Network Financial Services, we provide personal advice which involves assessing your financial goals/objectives and weighing them against your appetite for risk.
Getting started is as simple as contacting us and enquiring about having a well-diversified investment portfolio.
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