The Pros and Cons of Diversifying Your Investment Portfolio

If you’re new to investing, you may have heard the term “diversification” thrown around a lot. Wondering what exactly it means to diversify your portfolio?

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Although it may sound complicated, diversification is a simple concept. It essentially means making several smaller investments instead of one or two large ones. This can help you manage risk and ensure steady growth, but it also comes with a few drawbacks. Here’s what you need to know about the pros and cons of diversification.

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Understanding Diversification

Let’s start by defining the terms. Your investment portfolio is a collection of assets, such as stocks, bonds and mutual funds. These assets might be managed together or separately through multiple financial institutions.

Diversification, in financial terms, refers to the number of different assets in your portfolio. The more assets you own — across different financial sectors — the more diverse your portfolio is. For example, an investor who owns stock in a variety of companies as well as investment properties, a few mutual funds, exchange traded funds and certificates of deposit has a very diverse portfolio.

The main idea behind diversifying your portfolio is to avoid putting all your eggs in one basket. Although risk is an inevitable part of investing, you can protect yourself to an extent by owning multiple types of assets. That way, if one investment fails, it won’t devastate your entire portfolio.

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The Pros of Diversifying Your Investments

Many financial experts will tell you that diversifying your portfolio is a smart choice. Not only does it reduce risk, it comes with other advantages for your long-term financial success. Here are some of the most notable advantages of diversification:

Risk Mitigation

Diversification can lower your overall investment risk. However, it also allows you to mitigate risk when it comes to higher-stakes investments, as Harvard Business School explains .

High-risk yet potentially profitable investments include:

• Venture capital
• Initial public offerings
• Penny stocks
• Foreign currency
• Real estate investment trusts

Many successful investors include these assets in their portfolios despite a higher chance that their investment could fall through. The trick is to choose investments that complement each other, balancing your risk. So, for every risky investment you make, match it with a stable, long-term asset.

Meeting Short- and Long-Term Goals

Different types of investments come with different horizons or timelines, as CFI explains . A shorter horizon means the investment is likely to pay off relatively soon, while a longer horizon means the investment will grow steadily over a long period of time.

Diversifying your portfolio allows you to invest in multiple horizons. That way, you can grow your wealth for both short- and long-term goals. Saving for retirement or a child’s education, for example, is a long-term goal that you don’t want to risk — invest in steady growth options like a Roth IRA or 529 college savings account. On the other hand, if you want to use your portfolio for more immediate goals like buying a house, you might be interested in assets that can be easily liquidated.

Balancing these two types of investments means you don’t have to wait for your portfolio to pay off, but you aren’t neglecting your financial future either.

More Opportunities for Growth

Just as investing is inherently risky, it’s also inherently unpredictable. You never know when a sudden windfall or economic change could cause an asset’s value to skyrocket. The more you diversify your portfolio, the more opportunities you have for growth.

It’s important to balance these growth opportunities with risk mitigation. Investing in a real estate investment trust, for example, can result in a high yield due to favorable changes in the real estate market, but it’s also one of the riskier options, as Charles Schwab notes . A mix of investments in your portfolio allows you to take advantage of that growth opportunity without the high risk.

The Cons of Diversifying Your Investments

Diversification comes with significant advantages, but there are a few drawbacks to consider. Here’s why some investment experts might tell you not to diversify.

Limited Growth Per Asset

Diversification spreads your investment budget thin. Although it’s nice not to put all of your eggs in one basket, you only have so many eggs — and in general, the more you put into a single investment, the more you get out.

If you’re looking for a high return on a given asset, diversification can limit your growth. Some investors choose to accept the risk and concentrate their budget on one or two smart investments.

More To Learn

Smart investments take a lot of careful research. If you don’t have the budget for a professional financial advisor, it’s up to you to handle that research yourself. That means a lot of time spent learning about the various assets in your portfolio.

Having a lot to learn also means more opportunities for mistakes. You might feel more confident in your choices if you limit your investments to a few well-researched assets.

Potentially Higher Taxes

Every asset in your portfolio comes with its own tax implications. It’s important to understand how each asset is taxed and plan accordingly — otherwise, you could find yourself with a higher tax bill than you were expecting.

Again, this means a lot of time spent researching and planning. It also can hurt your financial growth if you don’t budget for potentially high taxes.

Should You Diversify?

New investors are often told that the best thing they can do for their portfolio is diversify. However, many investors choose to concentrate rather than diversify for a simplified experience and higher potential return — although doing so means accepting a higher risk.

Ultimately, it’s up to you to decide whether you want to divide your budget into multiple assets or stick to a few trusted options. Remember that you can always make changes, especially when it comes to short-term investments. It’s possible to start out with a diverse portfolio and concentrate in the future on your most profitable assets as you gain experience.

It is always a good idea to consult an investing advisor for guidance if you are just beginning.

This article originally appeared on GOBankingRates.com : The Pros and Cons of Diversifying Your Investment Portfolio