Risk is a component of investing. That is why diversification of financial instruments is the golden rule of any investment strategy to build a safe portfolio.
If we put all our eggs in one basket, we run the risk that, as we fall, they will all break. The same goes for investments. Concentrating them in one instrument exposes us to a higher risk of suffering high losses.
Investments and risk: an inescapable pair
Risk is a component of investments. However, diversifying financial instruments is the golden rule of any investment strategy to build a safe portfolio.
A diversified portfolio contains a mix of assets and financial instruments that limit exposure to the specific risks inherent in each individual investment.
The rationale is that a portfolio consisting of different types of assets reduces risk and volatility, producing greater long-term returns than an investment concentrated on a single asset.
Instead of investing in a single company, you target several stocks, perhaps in different sectors, to avoid the specific risks associated with a single stock.
An example of diversification by sector
Consider, for example, what happened in 2020. With lockdowns and travel restrictions due to the pandemic, energy company stocks plummeted.
Those who had focused their investments on one stock or the energy sector alone may have lost a lot in a short period.
By diversifying, however, one “spreads” one’s investments (and the associated risk) across different instruments in a way that balances risk.
No sector permanently enjoys market favor, so it is a good idea to never focus on one that may be doing well while ignoring the potential of others.
What types of diversification exist?
But it is not enough just to diversify stocks and sectors. You must also diversify the types of asset classes in which you invest, varying between stocks, bonds and currencies.
These instruments do not move in a coordinated manner, and sometimes declines in one are offset by rises in another and vice versa.
The same is true for diversification by geography. There are sometimes risk factors specific to a single region or area of the world to which others are immune.
Investing only in the BRICS, for example, exposes one to very high risk. Mixing different areas of the world, on the other hand, is an excellent idea for maximizing returns.
To return to the initial example: to reduce the risk of breaking all the eggs, you have to put them in different baskets.