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The secret to risk diversification: Why is the saying 'Don't put all your eggs in one basket' so important?
In the financial field, diversification is a method of allocating capital that can effectively reduce exposure to a single asset or risk. When investing in diversified assets, we can reduce risk or volatility and ultimately protect our investment. If asset price changes are not perfectly synchronized, a diversified portfolio will typically have less variability than the weighted average variation of its component assets, leading many investors toward a more solid financial future.
"Don't put all your eggs in one basket, this sentence tells the true meaning of diversification."
A simple example can explain the necessity of diversification. Suppose we put all the eggs in a basket. If the basket accidentally falls, all the eggs will break. If you put each egg in a different basket, although the risk of falling into one basket is higher, all eggs will not be lost. This metaphor also applies to financial investments.
Portfolios holding a single stock tend to be higher in risk. It's not unusual for a stock to drop 50% in a year, but the likelihood of such a huge drop in a portfolio of 20 different stocks is much less likely. Furthermore, if these stocks are distributed in different industries, company sizes and asset types, the risks will be further dispersed and the impact of market changes on individual stocks will be reduced.
"The purpose of diversified investment is to narrow the range of possible outcomes and avoid the risks caused by concentrated investment."
Since the mid-1970s, many financial experts have also begun to advocate geographic diversification. Allocating capital to emerging markets such as Asia Pacific and Latin America can effectively reduce overall investment risks while providing the opportunity to obtain higher returns. In the process of investment diversification, even if it does not guarantee a return that exceeds that of non-diversified investments, diversification can provide investors with some protection from the risk of underperformance of a single asset.
In a diversified portfolio, the expected returns for all assets can be considered the same. But in reality, some assets will perform better than others, so how to predict which asset will perform requires more professional analysis.
"Through diversification, investors become accustomed to reducing the worst possible performance, but also lose the opportunity to obtain the best single asset."
The diversity of investments does not require specific numbers to support it. There is a view that holding at least 30 stocks counts as diversification, but sometimes a handful of 10 carefully selected stocks can achieve this goal. Take index funds as an example. Most of them are designed to cover all available assets, aiming to allow investors to obtain the maximum diversification benefits in the market.
For how to maximize the diversification of your portfolio, experts recommend weighting investments based on risk. If we can plan backwards for the risks of assets, then the risks of all assets will be balanced in the portfolio. This strategy is not only theoretically feasible, but actually makes it easier to predict future risks.
"Correlation of assets plays an important role in diversification, and increasing the number of non-correlated assets can further reduce the volatility of a portfolio."
However, as portfolio assets sharply increase, the degree of risk diversification becomes more significant. When there is a positive correlation between the investments held, the overall variability of the portfolio may not be significantly reduced, but if there is a negative correlation, the risks are more easily balanced. This also shows that every investor should consider the correlation between assets when choosing assets in order to obtain the best diversification effect.
In summary, diversification not only reduces the possible downside risk of assets, but also provides a certain degree of loss protection. Such a strategy provides investors with relatively stable growth opportunities, allowing long-lasting financial planning to be executed. In this increasingly volatile market environment, how should each of our investors consider their own investment portfolio to achieve the best diversification effect?
