What is diversification and how can it mitigate risk
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Have you ever heard the saying "don't put all the eggs in one basket?" Diversification is actually a risk mitigation approach that includes distributing your money over a broad range of investments. The argument is that a diversified portfolio will on average produce superior long-term returns and reduce the risk of any one asset.
When it comes to peer-to-peer lending, diversification is a great strategy to reduce the risks involved. An investor's money might be lost if a borrower refuses or is unable to repay the whole loan amount (bad debt). While each P2P network has systems to monitor and collect bad debt, it might take months to settle so there is no assurance that you will receive all the money back.
The purpose of diversification is really to manage a risk-reward connection in such a way that the favourable performance of certain assets compensates for the less favourable performance of other investments. Building a portfolio in which the assets are not closely associated with one another helps achieve this goal and results in a superior risk-to-reward ratio.
How Diversification helps Mitigate Risk?
Diversify the kind of assets in which you invest your money
This is, in fact, a website devoted to peer-to-peer lending. Nevertheless, investments in P2P lending should only make up a small portion of a portfolio that include holdings in a variety of asset classes. You ought to give some thought to putting part of your money into investments in other asset groups, such as cash savings, real estate, and stocks and shares.
Use several P2P platforms
Because it is difficult and time - consuming to study a P2P network, register an account, and manage your assets, the majority of individuals naturally choose to remain with one platform rather than switching between many platforms. Having your money invested in a number of different platforms, however, lessens the impact on your portfolio in the event that one of the platforms fails, underperforms, or compromised by illegal activity.
Invest in a variety of financial products and marketplaces
P2P systems often concentrate their efforts on serving a single borrower lending market. This can refer to either personal loans, loans for businesses, or loans secured against property. As was just said, all of these different forms of loans come with their own unique set of market-related dangers. A fall in the price of housing, for instance, may imply that the property developer will not receive the valuation that was anticipated whenever the loan was carried out and would thus be unable to repay the whole amount. A rise in the unemployment rate may have an effect on personal loans, and any one of a variety of economic conditions may have an effect on a company's operations. So exposure to any of these markets will be reduced if you invest your money in a variety of other sorts of loans.
Lend money to a number of borrowers
This one really ought to go without saying. To lessen the likelihood of one of your borrowers going into default, you should distribute your funds over several borrowers using a peer-to-peer lending platform. When considering diversification options, it is important to keep in mind that certain borrowers have more than one loan on a given platform. This is because any financial troubles that arise with one borrower are likely to affect all of their loans. On certain platforms, loan diversification is handled automatically, either by default or as an additional function. You may also diversify your portfolio by self-selecting loans if your selected platform allows for this functionality; however, this strategy requires more time and effort. Make sure that there is enough loan supply in a platform before making a deposit. Wide diversification won’t be possible if there are not enough loans in a platform. Platforms like Robocash, Esketit and Bondora always have significant loan supply.
Is there any Problem with diversification?
The benefits of diversity are frequently emphasised by industry experts, however there are a few drawbacks associated with pursuing this approach. To begin, it is possible that maintaining a broad portfolio may be rather difficult, particularly if you have a number of different assets and investments.
Diversification may also result in financial burdens. Because the costs of various investment vehicles differ, buy or sell will have an impact on your overall financial situation, including transaction fees and brokerage charges. And while greater risk is accompanied with greater rewards, you run the danger of restricting the amount of money you make.
Next, take into consideration how difficult it often is. For instance, several fake investment products are created in order to cater to the varying degrees of risk tolerance exhibited by investors. These products are frequently difficult to understand, and they are not designed for novices or small investors. Bonds are a good way to diversify an investor's portfolio and protect them from the volatility of the stock market. Those with little investment skills and financial support might consider buying bonds.
Regrettably, not even the most thorough examination of a firm and its financial records can ensure that the investment will not result in a loss. Diversification does not guarantee profit, but it can lessen the damage that is done to your portfolio by fraudulent activity and inaccurate information.
The price fluctuations of an asset might be less volatile when an investor uses diversification to control risk. No matter how well-diversified the portfolio is, risk will always be an issue.
It is possible to limit overall risk associated with specific stocks, but broader market hazards influence practically every investment, thus diversification is essential. Finding the right balance between risk and reward is essential.