Meaning and benefits of 'diversification in financial markets Essay

Meaning and benefits of 'diversification in financial markets - Essay Example Some markets can be stable with a clear direction while others move up and down without any clear direction. Such markets are said to be volatile and investing in them can be extremely risky. A lot of volatility increases the chances of losing especially if the capital is not large enough to caution the investment from the volatility (Smith and Schinasi, 1999). Allocating Capital The amount of money to invest in each of the markets or instruments solely depends on the investor. There is a percentage of risk the investor is comfortable investing in each of the chosen portfolios. This should also work together with the behavior of the markets in the last few months or years. An investor can invest more percentage of the capital in stable markets and instruments as there is little or no risk. Volatile and unstable markets should only be allocated a small percentage of the capital. In fact, investors should avoid trading volatile markets. If all the markets of interest are very volatile, the investor should consider waiting for volatility to come down before investing. Diversification in the financial markets has many advantages, including; Guaranteed profits: diversification in financial markets almost guarantees profitability. This is because even in the worst-case scenario, some of the markets and instruments will generate profits. ... If the markets were going against the investors bet, they can close the positions at once and remain with little or no losses. With good money management skills, even the others should be able to generate profits after some time. The charges for trading in the various markets are relatively low compared to other types of investments. With that, most of the profits made are retained by the investor (Caruso, Silli, and Umlauft, 2005). Reduced Risk: investing in different portfolios reduces the risk exposure of the capital. As such, it would be hard to lose all the capital. Even if some of the portfolios go at a loss, the investor will be guaranteed that at least some of the portfolios are into profits. In some cases, investors can even hedge, in which case they can make profits in one market while another is negative (Madura, 2012). Leverage: some financial markets institutions work with margin trading. Investors are required to raise a certain proportion or percentage, and the broker tops it up allowing the investor to purchase more units than they would have purchased with their own money. Leverage can increase the profitability factor of an investment but can also lead to substantial losses. Diversification and leverage would allow the investor to venture into different markets and invest in many different investments with little capital (Gilchrist, 2003). Management of Capital: Diversification in financial markets allows easy management and preservation of capital. Investors have access to a variety of tools and software that assists them in determining how they are going to invest, the amount of investments to make on what elements and calculations of the risk to reward ratio.