We’ve all heard stories in which someone loses their entire life savings on investments that were too risky. In many cases, these huge losses are due to a single concentrated holding or a risky one-off investment. There are several things that you can do to prevent this type of loss when it comes to your investments.
Because every investment has some risk involved, the only way to avoid risk completely is to stay away from investing altogether. Therefore, investors need to find some balance between risky investments and experiencing gains to make it worth their while. Portfolio diversification helps achieve that balance by mitigating the risk of investing while still allowing for a return.
Portfolio Theory of Investing
All investors are aware that with higher risk comes the potential for higher reward, but how can we lower the risk of our investments and still hope to turn a profit? The basic principle of the portfolio theory is that you can maximize return and minimize risk by building a portfolio of assets whose returns are not correlated. This requires investing in various assets and industries to ensure parts of your portfolio are not too similar.
Investing in assets with little or no correlation prevents all areas of your portfolio from decreasing in value if one specific industry takes a hit. With the right mix of assets, some may even increase in value due to a decrease in another. By diversifying your portfolio, you’re providing protection when the market gets rough, allowing the fulfillment of long-term financial goals while minimizing the risk of losing it all along the way.
What Happens When You Fail to Diversify?
The burst of the dot-com bubble in 2000 is a great example of the importance of diversification. Prior to the burst, tech stocks appeared to be so lucrative that many viewed investing in anything else as absurd. After the bubble burst, investors were either glad they diversified or they were wishing they had. Those investing solely in tech stocks saw nearly their entire net worth disappear, while those who diversified had other assets in their portfolio to keep them afloat when the stock market crashed. In this case, as in so many others, diversification paid off.
Diversifying by Investing in Startups
Today’s investing environment provides the ability and freedom to choose exactly where you invest your money. Because single investments no longer require massive sums of money, an average investor can now back many companies instead of just one.
Startup investments are great assets to have when it comes to diversifying your portfolio, as they allow you to get a feel for products and get to know the teams behind them from the very beginning. You can also familiarize yourself with the opportunities, threats, and competition faced by each startup you invest in. And with startups in many different industries, you can invest in numerous startups while simultaneously diversifying and strengthening your portfolio.
Diversification isn’t the only way to see long-term gains on your investment, but it provides much more security than putting all your money in one location. Sure, you could invest everything you have in one promising industry, but if that industry takes a hit, you could lose your entire net worth. By diversifying your portfolio, you’re allowing yourself a better chance to achieve long term goals while providing safety along the way.