You can grow your wealth significantly through investing, but depending on your allocation, you could experience a bumpy ride. You trade risk for reward hoping that you can avoid losses, but bypassing them altogether is incredibly difficult.
You can, however, lessen them. If you are someone who prefers a smooth investment journey, here are three ways diversification can help.
1. Diversification lowers your risk
When you own only one or two stocks, you could have a really big win if the stocks do well but you could also lose a lot if they do badly. If you’re not comfortable with that trade-off, you can lower your risk through diversification.
In 2008, during the financial crisis, if you only owned stocks like Bear Stearns or Lehman Brothers, you would have seen your portfolio value hit zero. If, however, you owned all the stocks in the S&P 500 spanning multiple industries through an ETF like SPDR S&P 500 ETF (NYSEMKT: SPY), then your accounts still would’ve declined in value, but only by about 37%.
Adding more securities to your portfolio helps you mitigate concentration risk, assuming that they aren’t all the same type of stocks. Diversification looks different for everyone, and there is no rule of thumb for how many stocks you must own. But research has shown that by equally weighting 20 different stocks, you can reduce your volatility greatly.