Diversification is a time-tested strategy to spread your risk and optimize your returns. It is a sound principle to follow whether you are investing for your retirement, your children’s education, or are just seeking some quick short-term gains.
In spite of expert predictions and analyses, there is really no reliable way to state with any conviction what the markets will look like in the future. In such a scenario, diversification gives you two important advantages: 1) it sets off losses in one part of your portfolio with gains in another 2) it allows you to mix high risk, high return investments with low risk low return ones so that you can strike the right risk-return balance in your investments depending on your financial needs.
Many studies have shown that diversifying your portfolio can indeed offer risk minimization with optimum returns. Mutual funds offer a readymade diversified option for small investors who do not have the fund base or resources to adequately spread their investments.
Time diversification: It is impossible to predict when the markets will take a turn for the worse and when the prices will peak. In order to make the best of volatile prices, it is important to spread your investment over a period of time. Time diversification will make sure that you do not miss great opportunities, and do not put all your money in the market at an inappropriate time.
Location diversification: This kind of diversification involves creating a portfolio to handle local downturns. For instance, the economic crisis in Greece may affect share prices or home values there but for Greeks who had invested in foreign instruments – say US Bonds – their portfolio value may remain largely unaffected.
Asset diversification: A well-diversified portfolio has to include a healthy mix of different kinds of investment products. Bonds, stocks, mutual funds, ETFs all have their unique advantages, and they can be used to create a balanced portfolio.
Apart from these basic diversification techniques, the liquidity of your entire portfolio is another important factor that you should consider. If a significant portion of your funds are locked up in non-liquid assets like real estate, then it is important for you to balance this with some investments that are easier to convert to cash. This will give you access to your funds in case of an emergency and also improve the overall balance of your portfolio.