This article is about how you can use diversification to reduce your risks associated with investing. As a result, you can preserve your wealth but still be able to take advantage of the market stock high returns.
NOTE; One thing you should know: I was born and raised in Italy, so English isn’t my native language. This is the reason why my English sometimes might sound “funny”, but I had the deep desire to help others to achieve more with their finances and English is the best language to spread my knowledge in the world.
I’m constantly working on my portfolio diversification to improve the bottom line; over the years, I went from a single digit growth to a double-digit not by taking extra risks but by diversifying my portfolio strategically.
I was reading Sabeel’s blog and found interesting his way to diversify investments geographically, you can read his recent post; Geographical Revenue Diversification of My Holdings.
What is Diversification? Diversification is the process of allocating capital in a way with the goal to reduce risks.
Well here’s the truth: investing is risky.
But without investing you also risk to never retire (ok, if you have a paying job as CEO making more than US$ 200,000 per year and living a frugal lifestyle, you don’t need much of an investment strategy).
Did you ever heard the old say; “Don’t put all your eggs in one basket”. I’m sure you do.
People think they are diversifying when they aren’t. Sound impossible?
Let’s have a look at Mr. Tom investments to get a better grasp of the concept.
NOTE; The portfolio below is for the sake to get a better understanding of diversification. Type of assets and percentage of portfolio weight are purely casual.
Mr. Tom thinks to have a “diversify portfolio” (what his financial advisor is saying).
The portfolio is:
- 50% US Long-Term Bond ETF
- 50% S&P 500 Index
The amount invested is US$10,000.
Mt. Tom’s portfolio has a diversification in asset classes in a domestic portfolio. This is a good start for Mr. Tom in the world of investment, but more can be done to reduce his portfolio risks and increase returns drastically.
When investing, first we focus on reducing risks, second on capital gains.
“Rudy, investing isn’t all about making as much as possible?”
Yes and No.
The primary focus for any investor is “Capital Preservation”; Protecting the absolute monetary value of an asset as measured in nominal currency.
Keep savings in a bank account just because its perceived safe, isn’t going to preserve your capital.
Inflation reduces the purchasing power of currency over the years. This means, if today I can buy a burger with US$ 1, in ten years time the same burger will cost US$ 1.50, so my purchasing power has been eroded 50% during a period of 10 years.
During these 10 years, if my capital grows 50%, I achieved the goal to preserve my capital.
What about preserving your capital from the risks of investing?
In our example with Mr. Tom, he diversifies in two different asset classes; bonds and stocks.
During the 2008 financial crisis (December 2007 and ended in June 2009) both classes did poorly, however bonds hold up better than stocks.
Tom’s portfolio during the 18 months recession lost 21.1% in value. Tom’s was left with US$ 7,890 after the recession.
This article is my guest post on roadmap2retire.com. Carry on the reading by clicking: