The world of investment is a game of risk and probabilities. To make a profit, you have to have a little foresight, a little luck, and plenty of diversity in your portfolio.
When investors refer to “portfolio diversity,” they’re not talking about inclusionary social politics that comprise many think pieces. Rather, diversity in this case refers to the breadth of types of investments a portfolio manager chooses to make with the allotted amount of money.
Every investment comes with its share of “risk.” That is, some investments grow slowly but steadily upwards over a long period of time, while others can spike and plummet with less predictability, meaning that you can make a lot of money just as easily as you can lose a lot of money in such investments. Government bonds are some of the steadiest, most reliable investments available, but the return is rather low compared to some other options. Cocoa farming and trading, by contrast, is a highly volatile market since the success of the cocoa industry depends on climate, rainfall, plant viruses, insect infestations, and other factors that are beyond human control.
Economists and finance professionals devote a lot of their research capacity to understanding the nature of risk in the marketplace and how to strike the balance of healthy, well-calculated risk. According to Investopedia, risk comes in two very broad categories. Firstly there is Systematic Risk, which affects an entire portfolio — think the Great Recession of 2008 or a presidential election. Because such risks are so wide, it’s difficult to protect against them. Unsystematic risk, its counterpart, has more to do with individual investments — think of a labor strike.
For long term, sustainable success in the world of investment, they key is to diversity a portfolio to balance out your risks and rewards. If all your investment are low-risk, the return will be guaranteed, but not a fortune. On the other hand, if all your money is tied up in volatile stocks, you could strike it big just as easily as you could lose all your money. To construct a balanced portfolio, investors need to ensure that money is spread broadly among many industries, vehicles, and risk levels. A plethora of investment types ensures that a portfolio can weather a bit of a storm in any one of its areas.
Diversifying a portfolio will allow for a bit of a pendulum effect. Think back to your basic Economics 101 course that talked about supplementary goods — for this hypothetical example, we’ll choose mittens and bikinis. Imaginably, people will not need these to items at the same time, and each one’s sales along with the stock value of the producers’ company will swell and dip seasonally. Diversifying your portfolio to include a little bit of both will keep the investments balanced while each one is in its off season.
Sound investing practice dictates that portfolio diversity is key to long term success. From risk to industry to vehicle, diversity will ensure a sound portfolio largely immune to the whims of the market in the very long run.