October 16, 2021

Why diversification matters in investing ?

The diversification can be defined as the division of their investment in different instruments – such as equities, funds, bonds and other belonging to different industries or geographic areas – in order to reduce the total risk.

It is a concept that returns to the fore in our country every time we come across a business or banking failure . How many times, in the recent cases of bankruptcy of an institution, have you heard the story of a single investor convinced – in good or bad faith – to invest, for example, all his liquidation on the shares of the bank in crisis of the moment? Here, beyond the considerations on the different responsibilities of individuals (which must be pursued harshly in any case, in the event that there is a scam or a lack of explanation of the risks) there is no doubt that many of these cases would not occur if all the subjects had this golden rule very clear. Not the panacea for all ills, but certainly a way to strengthen the security strings on your money.

In this guide we see how diversification works and we will learn more about why diversifying your investment is important.

Diversification, How It Works

But why does diversification reduce risk? The common sense of the old adage is not valid (only) that if we put all the eggs in a basket we run the risk that they will all break if the latter falls. There is also a mathematical explanation behind it, which economists have worked on the proof. A fundamental contribution to the subject came from Harry Markowitz . In the 1950s, the American economist developed a theory to measure the risk of various financial instruments. And, above all, how these could be combined together to get the maximum return for a given risk. Or, if we want to see it in a specular way, as by combining different instruments together (i.e. not perfectly correlated in their performances)the total risk of the portfolio can be kept more under control .

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So why diversify your investment?

Assuming that portfolio diversification cannot protect against every risk , implementing it is one of the first rules to sleep peacefully . It seems rather unlikely, in fact, that several assets in a portfolio – if chosen correctly – could all collapse together.

Considering that diversification is a long-term strategy, this approach does not guarantee a complete defense against fluctuations. Short-term fluctuations are therefore inevitable and must be reckoned with.

Furthermore, especially if done in an inefficient way, negatively correlated assets (the growth of one, in general, loses the other) are a good thing, in theory, but also increase the chances of calming overall returns. However, when evaluating the performance of a financial instrument, it is not necessary to measure only the absolute return but the return parameterized to the volatility generated and in this sense diversification is a precious ally.

In other words, diversification is important because it protects investors from negative long-term results (the only time frame that every investor should keep track of) by distributing the risks across different stocks and therefore reducing the likelihood of suffering heavy losses.

How To Diversify Your Investment

But how to pursue proper diversification? You can do it yourself, spending time and assuming you have the right skills . Or by relying on a person who does it professionally, who has all the tools to build the perfect portfolio possible in terms of diversification .

Operate a correct diversification, with the right weights of the various asset classes and the various geographies that allows not to lose the opportunities on the market, reaching an optimal balance between risk and return . Today, thanks to the opportunities offered by digital, this type of advice is available to most investors.

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