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| *Ostroff, Fair and Company>>>Investing |
Why do most investors hold diversified portfolios? |
Why do most investors hold diversified portfolios? Diversification means having a financial interest in several different types of investments. My understanding is that the need for diversification is to minimize risk and to increase the overall income generated within a portfolio. For example, the higher risk investment generally yields a higher return and the more conservative or lower risk investment a lower return. Therefore combining investments of higher and lower risk and return theoritically helps to maximize the return on the investment while still insulating the investor from the potential loss from the high risk investment. I hope this makes sense, good luck and happy investing!! never put all of your eggs in 1 basket Fear of loss, especially large losses, but non-diversified portfolios maximize the chance for a large gain. Spread your risk. 1) In a portfolio with multiple asset classes, there is a good chance at least one class will yield positive results in any given year. This helps neutralize the negative returns from other assets. (And the flip side is true; usually one or more classes produce negative returns which counteract some of the positive gains from the others.) Thus, the combined result is a portfolio with less volatility than each individual asset class. In other words, the value of your overall portfolio will not jump up and down as severe as it would were all your money concentrated in only one asset class. 2) The positive years usually outnumber the negative years. And, the returns from positive years are usually greater than the losses from negative years. So, over the long run, the odds are stacked in your favor. Using multiple asset classes that are not correlated, you increase the chance that your overall portfolio experiences positive returns. 3) When you rebalance, you are forcing yourself to sell some of the better-performing assets and use that money to buy the worst-performing assets for that year. Since reversion-to-the-mean is present over long periods of time, your bad-performing assets usually revert to positive gains down the road. When you rebalanced, you purchased some of those shares at a discount, giving you a bigger gain when they revert. Over time, asset classes cycle between up years and down years. Ideally, the best time to buy shares is after they have lost value, something that is not intuitive to most people. Rebalancing is the discipline needed to overcome your natural instincts and make that counter-intuitive decision. Why do most investers diversify? Because if they don't, they will be risking their entire investment in one entity. If that entity fails, and the investor has all his principal in one place, he'll lose a lot of it. Diversification is a tool used to control risk. WIth every investment, there is an inherent risk of losing one's principal. When an investor diversifies his holdings, he is spreading his principal across several investments, perhaps in different sectors, market caps, etc. Thereby if one investment tanks, your losses will have been cushioned by having multiple investments. |
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