Investing in a wide variety of assets with your money at different times is an example of diversification, which is a strategy used to lower risk. Your investing success should not be too reliant on the performance of a single asset, which is why having a diverse investment portfolio is so important.
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TABLE OF CONTENTS
- What is diversification?
- Why is diversification important?
- Does diversification work?
- How to build a diversified investment portfolio
What is diversification?
Diversification is a common investment strategy that involves spreading an investor’s portfolio across a variety of different asset classes and types of securities. The purpose of diversification is to reduce the risk of loss due to the volatility of the market. It is a component of something that is known as asset allocation, which refers to the proportion of a portfolio that is invested in different asset classes. Stocks, bonds, and cash are the three asset types that are most often encountered (or cash equivalents). In order to achieve diversification, investors will combine assets that have little in common with one another so that their portfolios do not have an excessive amount of exposure to any one asset class or market sector individually.
Investors may choose from a wide variety of investment vehicles, each of which comes with its own set of benefits and drawbacks. Diversity by asset class, diversification within asset classes, and diversification beyond asset class are three of the most frequent ways that a portfolio might be diversified.
Illustration of diversification
Imagine you put all of your money into Apple stock and nothing else (AAPL). Since Apple is a technology business, this indicates that your asset allocation should be composed entirely of equity (also known as stock), with the whole of it being invested in the technology sector of the market. This strategy is fraught with peril owing to the fact that if the price of Apple stock were to fall as a result of unanticipated events, the results would be detrimental to your whole investing portfolio. In the event that the technology industry as a whole is severely affected, even if you diversify your holdings within the technology sector by investing in other technology businesses, your portfolio will still suffer a significant loss.
It is necessary to include stocks from a wide variety of industries if one wishes to achieve an appropriate level of portfolio diversification. In spite of this, you could also wish to include bonds or other fixed-income instruments in your portfolio as a kind of protection against a decline in the overall stock market.
Increasing your returns on investments while simultaneously lowering your exposure to risk can be accomplished through the use of diversification. You may shield your portfolio from the effects of market volatility by avoiding the practice of putting all of your eggs in a single basket. Every investor’s definition of diversification will likely be somewhat unique. When constructing a portfolio to meet the specific requirements of a certain client, it is important to take into account a variety of factors, including the amount of time an investor is willing to wait before taking risks and their level of risk tolerance. Your investment accounts may be diversified in a stress-free manner thanks to the abundance of options that are now at your disposal.
Diversification across the various asset classes
Stocks, bonds, and cash are the three primary broad asset groups that make up the whole of an investment portfolio.
- Investors have the opportunity to own a portion of a firm by purchasing stocks, also known as equities. Stocks have the potential for the greatest long-term returns but also the greatest degree of short-term volatility, particularly when the economy is weakening.
- When investors lend money to a corporation or government, they are rewarded with interest in the form of bonds (also known as fixed income). Bonds are sources of income with moderate yields, but their value is often lower during times when the economy is growing. In general, bonds and stocks have a connection that is opposite to one another.
- The money that you have in your savings account, wallet, or stashed under your pillow is considered cash (or cash equivalents). Cash is a low-risk investment with a low potential return on both counts. Cash may operate as a buffer against market volatility or unforeseen costs, and it can also serve as “dry gunpowder” to invest when the moment is right.
Other types of assets, such as real estate and commodities (natural resources and precious metals), as well as alternative investments, are also considered to be asset classes. Because these asset classes often have a weaker connection to the stock market, they may be an effective means of assisting in the process of diversification.
Diversification of holdings within respective asset types
After diversifying their holdings across a variety of assets at the portfolio level, investors may take the process one step further by subdividing the primary asset classes into other categories or analyzing each subclass in more depth.
a diversification strategy that goes beyond asset type
The conventional asset classes that are typically held in investment accounts are not the only potential target for diversification. Since investment accounts are exposed to fluctuations in the market, the returns on such accounts are not guaranteed. On the other hand, there are a variety of different product categories, such as pensions, annuities, and insurance products, which are able to give assured income streams and returns. When looking to lower their overall risk exposure, investors often diversify their portfolios by allocating their investment funds among a variety of product categories.
Why is diversification important?
Diversification offers what is referred to in the business world as a “free lunch,” which is a reduction in total risk in conjunction with an increase in the possibility for overall return. This is due to the fact that certain assets will have strong performance while others will have weak performance. However, their places might be switched the following year, with the teams who were previously in last place becoming the champions. A well-diversified stock portfolio, on the other hand, is more likely to earn the market’s average long-term historic return, regardless of which companies actually wind up being the winners. Nevertheless, throughout shorter time frames, that return may be very variable.
The following figure, courtesy of J.P. Morgan, illustrates the fluctuation in the value of several forms of investments from the years 2004 to 2018. The “asset allocation portfolio,” which is a diversified portfolio with a variety of investments, manages to stay in the middle of the pack despite the volatile nature of the market. Over the course of the time period, it achieves an annualized return of 6.2%, which smooths out the ride.
More about this graphic
Having a diversified portfolio reduces the risk that a single holding may drag down the performance of your whole portfolio. You never quite get all of the unexpected benefits that come with a shooting star, and this is the trade-off. The end result of diversity is a slower and more consistent performance as well as smoother returns, which never move too fast in any direction. Many investors feel more at peace as a result of the decreased volatility.
Does diversification work?
Diversification is a simple method that can cut down on the amount of risk in your investment portfolio, but it cannot eliminate risk entirely. There are two main categories of risk associated with investments:
- Market risk (systematic risk): Owning any asset, even cash, exposes one to these dangers; yes, even cash. There is a possibility that the value of all assets on the market may decrease as a result of investors’ preferences, a shift in interest rates, or some other reason such as conflict or weather.
- Asset-specific risks (unsystematic risk): These dangers are posed by the investments or the businesses on their own. Such risks include the success of a company’s products, the management’s performance, and the stock price.
By spreading your money over a variety of assets, you may drastically cut down on the risk associated with any one particular investment. However, no matter how hard you try, there is just no way to eliminate market risk via the use of diversity. It’s just the way things are.
You won’t get the advantages of diversity if you fill your portfolio with firms that operate inside a single market or sector; doing so might actually expose you to more risk. During the height of the global financial crisis, having a portfolio consisting entirely of bank stocks must have been a living hell. Nevertheless, some investors bought into it, despite the fact that it caused them to suffer from nausea and sleeplessness. Because the risks faced by firms within an industry are comparable, a portfolio has to have holdings from a diverse range of sectors. Keep in mind that portfolios need to be diverse in terms of business industry, firm size, and geographic location in order to minimize company-specific risk.
How to build a diversified investment portfolio
Developing a strategy for your investment portfolio’s diversification may sound like a difficult task, particularly if you lack the time, ability, or desire to research individual stocks or investigate whether a company’s bonds are worth owning. However, this is not the case if you use a diversified investment approach. The vast majority of securities may be obtained either alone or in groups, such as via the investment of money in a mutual fund, index fund, or exchange-traded fund (ETF). For instance, investing in mutual funds or exchange-traded funds (ETFs) that are straightforward, low-cost, and “set it and forget it,” particularly index funds and target-date funds, may swiftly and securely reduce risk while also diversifying a portfolio. Robo-advisors are yet another alternative that may assist investors in diversifying their investment portfolios.