Jul 12, 2022
Diversification
Several golden rules fall under "investing 101."
You have probably already heard about or read that diversification reduces risk. But what does this mean? A diverse investment portfolio, composed of different categories of assets, reduces risk factors. The more varied, the investment opportunities you enter, the better positioned you are to weather a negative economic shock.
For example, the economy enters a bear market, meaning your stock shares are losing value, however, you are also invested in other assets beyond the stock market, like real estate properties. Since real estate has a low correlation to the stock market, the properties you have invested in continue growing in value. Your diverse investment portfolio helps you respond to periods of uncertainty, after all, you have alternative and stable financial resources, like real estate, at your disposal.
Even within an asset category, you can diversify your holdings. For instance, in the stock market, you can buy shares of technology stocks in addition to several shares of energy stocks. Different stock categories perform differently under macroeconomic conditions. In the event of technology as a sector underperforming, your equities portfolio will fare just fine, thanks to your energy stocks. The value of energy stocks is more closely related to energy consumption than to marketing budgets.
The same diversification strategy can be employed in the real estate domain. You can invest in different categories of real estate like residential properties and commercial properties. You can invest in different geographical areas like cities and rural regions, the east coast, and the midwest. You can even invest in multiple properties falling under the same category and location and still reduce your risk level. For example, if one of your properties suffers damage from a kitchen fire, other properties in the neighborhood will continue to fare adequately. Investment diversification suggests your capital comes in from several sources.
Ultimately, diversification protects you in the case of an economic downturn or even something as minor as an unexpected vacancy. If you own three residential properties and one becomes vacant, the other two properties can help cover the losses incurred from the vacant property until you identify a suitable tenant. However, imagine you own a single home that becomes unexpectedly vacant, and now you are responsible for covering the housing bills and mortgage- where will you find the capital? Diversification is a golden rule for a good reason.
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