What is Diversification and How to Protect Your Investment Portfolio

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There’s a famous investing proverb that says you must never put all your eggs in one basket. It makes sense. If you drop that one basket, you can lose ALL your eggs. Similar to that, it’s wise to NOT put all your cash in just one investment. If that particular investment fails, you can lose a LOT of money.

So how do you protect your investment money? Simple. You must learn to diversify your portfolio! Instead of putting ALL your money in just ONE investment (one company, one kind of investment, etc.), you have to invest in MANY!

Here are three simple ways to use diversification to protect your investment money.

What is Diversification and How to Protect Your Investment Portfolio

Let’s have a disclaimer first. These are just some of the most basic strategies for diversifying your portfolio (investments you own). You must not take them as gospel, and they will not work all the time. You can learn a few basics here, but in order to get good at choosing investments and managing your money, you will still need to do your own research and find strategies that work for you. Also, remember that even though there are sound principles here, real life doesn’t always go as planned and there will always be some risk involved.

 

1. Diversify across investment vehicles

Note for beginners: “Investment vehicles” does not mean “invest in cars”. It’s a term for “kinds of investments”, like stocks, bonds, real estate, mutual funds, ETFs, money market, and other kinds of assets.

Markets crash all the time, and they crash when we least expect it. What would happen if you invested ALL your money in stocks before the stock market crashes? What if you invested ALL your money in real estate, and the real estate marked crashed? You’ll be in big trouble, that’s what.

To avoid those situations, you must learn to invest your money in different kinds of investments! Don’t just put all your money in stocks, or bonds, or money markets, or mutual funds, or real estate. Instead of investing 100% of your money on one thing, split up your budget and invest your money in a mix of them.

As for how much of your money you should invest in stocks, bonds, mutual funds, real estate, or other investments, that will depend on your investment strategy. For example, if you’re young and you still have a lot of earning potential, you can invest more in riskier stocks. On the other hand, if you’re growing older and you need a more stable portfolio or you can’t stand the stock market’s up and downs, you can invest more in bonds while leaving a bit of money in stocks for a little more growth.

2. Diversify across companies and industries

One of the most common mistakes I’ve seen people make, especially in the Philippines where I live, is that they invest all their savings in one company’s stock or one mutual fund because their friend or family member recommended it… and through sheer bad luck, that particular company or fund’s value starts crashing, they sell in a panic, and lose money. Worse, if it’s actually a great company and the value of the stock or fund increases over time, they lost the opportunity because they sold too early.

Again, markets and investments go up and down, and unless you’re really, REALLY good at reading them, it’s much better for you to diversify and invest in many different QUALITY companies’ stocks and funds.

By the way, it’s not enough to diversify and invest in different companies. You have to diversify with different industries as well. Just imagine investing all your cash in ten different companies… but they’re all technology stocks and the tech bubble burst like what happened in the 1990s to 2000s. Imagine if you invested in real estate companies and the real estate market crashed. That’s why you should vary your investments as much as possible.

The same logic applies to mutual funds (and ETFs) as well. If you invest in several funds that have the same strategy and they ALL invest in the same companies’ stocks, then it’s like you haven’t diversified at all. It would have been better if you invested in many kinds of funds, like putting a little in a stock index fund, an aggressive stock growth fund, a bond fund, and a money market fund.

3. Diversify across time: “Dollar-cost averaging”

This is the second part of the common mistakes people make. People are tempted to start investing when stock prices are increasing so they buy shares when they’re overpriced. What goes up must come down, and when the price inevitably falls to the “real” value (also called a “correction”), they panic, sell, and lose money.

Dollar cost averaging, also known as “money cost averaging” or “peso cost averaging” in the Philippines, is one way to minimize that loss.

How do you use this technique? Simple. Instead of investing a gigantic sum of money all at once (e.g. invest $1,200 all at once), you invest a certain amount money on a great investment at a certain schedule, like investing $100 every month or investing $300 every quarter. You must also continue even if the market rises or falls.

The technique works because you buy less shares when they are too expensive, but you get to buy MORE shares when they are cheap.

It rarely ever happens like this in real life, but we’re using this hypothetical or imaginary example for how it works:

1. On June, a food company’s share costs $50 each. By investing $100, you bought two shares. (Total: $100 invested, 2 shares.)
2. By July, the shares increased to $100 each and you were only able to buy one. (Total: $200 invested, 3 shares.)
3. By August, the shares DROPPED to $20 each and you LOST money. You still invest $100 in it anyway because according to your research it’s still a good company and you were able to buy 5 shares. (Total: $300 invested, 8 shares.)
4. By September, the shares returned to the normal $50 price. You invested $100 to buy two shares. (Total: 10 shares, $400 invested.)

So what’s your total financial standing there? You invested $400 to get 10 shares… but 10 shares at $50 each means you have $500 in your portfolio! You gained a $100 profit, even though the share price went back to the original $50!

Again, by investing the same amount of money at a certain schedule, you get to mostly reduce the effects of the market’s ups and downs. You get to buy less when things are too expensive so you lose less money when prices decrease, and you buy more when things are cheap so you earn more when the prices increase to their correct values.

Take note though that like every investing tip, this will NOT work on BAD investments and scams. This is one good technique for beginners, but you must always remember to do your own research.

Diversification is a good way to reduce risk, but it minimizes potential returns as well. Instead of focusing your money on a few, well-chosen excellent investments that have great earning potential, you spread it out to avoid losing a lot if the stuff you chose fail. If you’re a beginner, it’s much better to be safe than sorry. Remember, you probably won’t have enough experience to tell if that “awesome investment” your friend told you about is good or bad, so don’t take your chances with your cash.

That’s it for now and remember, before you start investing you have to do your own research! Don’t just rely on what friends and family say. Read books, read more articles, and invest only when it makes sense to invest. It’s your money after all. The more you know, the better your potential returns, and the lower your risks of getting scammed.

 

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I hope you enjoyed reading this article! If you want to learn more, check out a few of our other personal finance articles here:

• Investing Money for Beginners: Five Common Investment Vehicles to Check Out
• Personal Finance Basics: The Beginner’s Guide to Wise Money Management
• Choosing the Best Stocks: 10 Investing Terms you HAVE to Learn