Investors should practice diversification, that’s what experienced traders and investors always say. While there is no wrong about diversification, it is important to remember that it doesn’t always work. It’s the same concept as there is no perfect investment. Not all strategies work all the time, which is why it is very important to study first before you do anything that would pose risk to your money. Diversification is still part of the process if you are investing but make sure you are choosing the right investment for you. Today, I will show you why diversification is not always the answer.
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It is true that when you diversify, you try to minimize the risk. However, it’s not that effective at minimizing losses especially if you try to diversify by buying different stocks but they are still driven by correlation. This could mean that you bought stocks but there are still similarities that could create risk. If one of your stocks go down during a stock market crisis, the others will be affected because they are correlated. Losses can reach as high as 50% if diversification is not done properly in the stock market.
Yes, diversification unlocks many opportunities when the market is in good behavior. It entices investors to buy stocks that have good trends and the tendency to buy stocks with similar characteristics is high during this time. The concept of opening new opportunities will be retracted once the market crashes because for sure, stocks with similar characteristics will go down as one. So how do you avoid this dangerous situation? Pick stocks that are not correlated but still perform well when the market is up. Proper diversification is needed at this point.
If I were to ask you why do you need to diversify, what would you say? Is it to earn more from different portfolios or reduce the risk of losing money? Some would say they want to invest in different investments and some would probably go for diversification to avoid higher risk. If you say the latter, it is where the idea of de-risking enters. Diversification is not always the answer if you mainly do it for de-risking. You won’t earn that much if you will forever avoid risks. Build up your confidence so you would be able to trade and invest well.