Diversification is the simplest and most effective method to avoid concentration of risk in an investment portfolio. In the following article we will see what it consists of, its advantages and disadvantages. As a novelty, this article includes an explanatory video about the lesson.
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What is diversification?
The concept of diversification is very simple. Diversifying consists of investing our assets in different assets whose profitability is not correlated.
In other words, it consists of following the popular wisdom not to put all the new ones in the same basket.
What does this mean that asset returns are uncorrelated?
Well, to diversify it is not enough to invest in different companies. It is also important that they are not exposed to the same risks, since they can make us lose money all of them for the same cause.
For example, an investment portfolio will not be well diversified if we buy shares of companies in the same sector or we buy shares of companies exposed to the same country or economic area.
Therefore, it is not enough to diversify, it is also necessary to do it properly.
Advantages of diversifying our portfolio
The main advantage of diversification is that it reduces the risk of our portfolio. In this way we reduce the two main risks:
- Intrinsic business risk
- Investment risk
In addition, it has two characteristics that make it an ideal method to reduce risk in our portfolios.
- On the one hand, it is simple, since it is only necessary to buy shares or assets that are not correlated.
- On the other, it is effective, since it protects us from unexpected events and our own investment errors.
For this reason, there is unanimity about the advantages of diversification when investing, not only in value investing, but in all investment and speculation styles.
Disadvantages of diversification
The main downside to diversification is that it means moving away from investing in our best ideas to investing in not so good ideas, which can hurt our profitability.
Furthermore, diversification comes at a cost in time. It is not the same effort that we have to dedicate to analyze 2 or 3 companies that we need to manage a portfolio of 15 or 20.
Despite these disadvantages, I am a strong advocate of diversification in our portfolios, especially if you are among those who are still learning to invest.
As always, this is very opinion, so I am open to discussion in the comments.
What do you think of diversification?
How much diversification is appropriate?
What did you see in the video accompanying the article?
I await your comment!