How Does Diversification Strengthen An Investor’s Portfolio
We can all agree that it is conventional wisdom to avoid putting all your eggs in one basket? Many people take this approach when it comes to investment. Others prefer a more precise approach.
For them, spreading out their investments could lead to diminishing returns as they would have less money to put on valuable assets. No matter your stance on this issue, it is indisputable that there are some benefits to diversifying your investments.
This article will discuss the various portfolio diversification types and how they improve your investment. You will also learn the difference between asset allocation and portfolio diversification, why diversification is crucial, and the relationship between diversification and portfolio risk.
What is Portfolio Diversification?
Portfolio diversification is a risk management strategy that mixes various investments or assets in one portfolio. An investor who desires to diversify his portfolio does well to mix several types of asset classes. For example, he could mix the often volatile purchase of public stocks with more stable assets like bonds. That way, he reduces his exposure to one set of investments.
This approach benefits the investor because all securities or assets in his portfolio will not grow simultaneously. If one security takes a turn for the worse, he can still have a strong portfolio as long as the other assets perform strongly.
Also, he doesn’t get to tie all his money in one unfavorable stock, asset, or industry; He can spread his investments across several locations, industries, and types of securities. Diversification may not always guarantee capital preservation, but it can cause the portfolio to see more or less constant investment growth over an extended period.
Before we can delve into the types of diversification, we need to understand some basic investment terms. Here are a few:
Securities: are passive money investments in a joint enterprise with the expectation of profits. They generally refer to stocks, bonds, or commodities; they can also refer to traded financial instruments.
Asset Classes: these are investment types with similar characteristics; this means that securities in the same asset classes will share similar risks while those in different asset classes will have different risks. The primary types of asset classes are stock, bond, and cash.
Individual Stocks: are securities that entitle the owner to partial ownership of a public entity, like a corporation. There are different types of stock- public stocks, foreign stocks, domestic stocks, etc.
Fixed Investment Funds: these are also called bonds. They function as debt repayment with interest schemes, and the owner is assured of a predetermined amount over a certain period. They are considered the most stable forms of investment.
Market Funds: these are best described as investment vehicles that allow you to purchase a wide range of securities through a single investment package. They are usually done in large groups by a savvy investor.
4 Types of Portfolio Diversification
Portfolio diversification will be pointless if not pursued systematically. To adequately diversify your portfolio, you need to know the various types of portfolio diversification:
1. Asset Diversification
An investor spreads his capital across a mix of stocks, bonds, and other investments. This portfolio diversification helps the investor right-size his exposure to different market parts; it is the backbone of investment diversification.
If an investor invests only in stocks, he risks losing all his money in a market downturn. On the other hand, if he only invests in stocks, he might miss out on some significant gains he could have gotten from more profitable stocks.
Asset Diversification enables him to run the risk and gains of different asset classes in a way that doesn’t wholly threaten his capital or deprive him of gains. Usually, investors choose a 60-40 formula with 60% of capital going to stocks and 40% to bonds. The idea is that the bonds would serve as a hedge against typical stock volatility.
2. Industry Diversification
Many rookie investors make the mistake of throwing all their capital into the hottest industry at the moment, but a wise investor will try to invest in as many industries as possible.
This diversification allows the investor to profit from industries he might have overlooked. Also, he can mitigate his losses if the invested industry crashes. An excellent way to go about this sort of investment is by hiring expert researchers and investment specialists.
3. Time Diversification
Time Diversification is an often overlooked form of portfolio diversification because it focuses on duration rather than assets and industries. It involves investing in both long-term and short-term interests. Once you get the short-term gains, you can reinvest your interests in other long-term pursuits.
This method is particularly effective because time is just as crucial in investment. Compound interests escalate over time, the market needs time to right itself, and you need time to make valuable predictions about the market. Balancing short-term and long-term investments mean consistently adding more capital to your portfolio.
4. Location or Geographical Diversification
A country’s politics, policies, laws, and even geography can significantly impact business, which is why an intelligent investor can invest some capital in a different but more favorable political climate. Different countries have different types of risks.
Warning: Diversification can help an investor reduce risk, but he must do this in moderation. In diversifying his investments, the investor runs the risk of over-diversification, a situation where he spreads his capital across too many asset classes and industries.
Over-diversification has negative consequences as the investor will be unable to make much profit from his investments and could even expose himself to more risk. Investment experts recommend a maximum of 50 stocks or less at a time.
Asset Allocation vs. Diversification
Many confuse asset allocation for portfolio diversification because the terms have similar meanings but don’t necessarily mean the same thing.
Asset allocation refers to how an investor spreads his investment across different asset classes. Hence, it is the percentage of stocks, bonds, or cash in your portfolio. On the other hand, diversification is spreading your assets across various asset classes to reduce investment risk.
While both terms are generally concerned with the same thing, asset allocation refers to the present state of your portfolio. In contrast, diversification refers to the process or act of allocating assets in your portfolio. Asset allocation is passive, while diversification is active.
Why is Portfolio Diversification Important?
One of the most significant importance of portfolio diversification is that it allows you to limit the losses. Many assets can be very volatile and unpredictable. Investing too much in one type of asset class is extremely risky and ultimately costly should the market take an unprecedented turn.
On the flip side, proper portfolio diversification enables you to balance potential risks and gains. If the market goes downward, your other investments in a different asset class can act as a hedge against absolute financial disaster. It also prevents the investor from being too conservative and losing out on potentially lucrative deals. Ultimately, diversifying your portfolio will depend on your risk tolerance, financial situation, and long-term goals.
Benefits of Portfolio Diversification
Portfolio diversification is one of the essential principles of Modern Portfolio Theory (MPT) because the practice has several benefits. Here are just a few:
Portfolio Diversification Reduces Portfolio Risk
There are two types of risks in portfolio combination- systematic and unsystematic. Systematic risks cut across all asset classes and cannot be diversifiable. But unsystematic risks are risks that affect a specific asset class or company. Portfolio diversification helps the investor reduce unsystematic risks.
It Enhances Risk-Adjusted Return
Different investments have different risks. An investment that takes more risk is more likely to lead to loss; Portfolio diversification helps you evaluate the amount of risk each investment will take and make an informed decision. Diversified portfolios allow for smoother and more consistent returns, especially long-term investments.
It Aids in Balancing Your Economic Balance Sheet
A traditional economic balance sheet contains two segments- financial and human capital columns. Financial capital refers to the investor’s assets, while human capital refers to the amount the investor will earn depending on his field.
Many investors tend to have a bias toward the field they either work in or are familiar with. However, when they adopt a diversification policy, they ensure that they check their bias and invest their financial capital in fields outside their human capital field. This way, he won’t be hard hit if there’s a blow to his human capital.
Increased Exposure and Opportunity
Many markets often experience a rotational period where some fields receive more investments than others. Some of these fields may be unknown to the investor. Portfolio diversification helps investors discover these fields and capitalize on them when they are on the rise. That way, the portfolio always has some exposure to leading sectors and markets.
Relationship Between Diversification And Portfolio Risk
Portfolio risk is one of the most critical risks an investor should be aware of because it doesn’t just affect one of the assets; it affects the entire portfolio.
Portfolio risk is the possibility that the combination of assets or units within the investments you own would fail to meet the financial objectives. Portfolio risk is inversely proportional to portfolio diversification.
Diversification is meant to reduce or eliminate portfolio risk drastically. The more diverse a group of assets are, the less chance they have of failing simultaneously. A properly diversified portfolio will then have very little or no portfolio risk because the odds don’t support the possibility. Understanding the relationship between portfolio risk and diversification will help the investor avoid putting himself in a situation where his portfolio works against him.
Pros And Cons of a Diversified Portfolio
Portfolio diversification are about reducing risk by sharing capital between high reward but more volatile securities and low reward but less volatile securities. While this method can limit risks and losses, it also has the downside of limiting potential profits. Here are some pros and cons of diversifying your portfolio.
Pros of Portfolio Diversification
Portfolio Diversification has many tested benefits. Here are some of them:
Leveling Out Volatility and Risk
The most apparent advantage of diversification is that it mitigates risk and limits the loss in the possibility of a market downturn. Because good diversification works across several asset classes, you will rarely have a case where all asset classes fail simultaneously. Experts predict that diversification can reduce about 50% of potential capital loss in any investment.
Aligning With Your Financial Goals
Diversifying your portfolio helps you invest in different investment instruments for different time horizons. This option is available when an investor uses a Time Portfolio Diversification, where investments combine long-term and short-term goals. This way, you can always have the capital to address various needs in a fiscal year.
Diverse Growth Opportunities
Diversification can benefit from various asset classes’ different factors. The different types of portfolio diversification come with their unique attributes. For example, policies of different countries can suddenly benefit you if you have used geographical diversification.
Cons of Portfolio Diversification
Diversification has many benefits, but it also has a few downsides. These are just a few:
Potentially Diminishing Returns
Just as diversification protects you from risk, it can also limit the number of profits you make. Many investors use 40% of their capital to invest in bonds that are low yielding, and that capital could easily have gone to high-performing stocks.
Exhaustive Monitoring Requirement
Keeping that many assets across the various asset classes can be very exhausting, especially if investing is a part-time job, and it can take a toll on your daily job.
Transaction Costs Soon Add Up
Transaction costs of buying stocks and bonds can gradually eat into profit. Also, some investors need to hire experts and researchers, which also comes at a cost.
Portfolio diversification is an excellent way to limit risk in Real estate investment. The best way to do this is by investing across several asset classes to reduce portfolio risk. You can choose from various forms of diversification but be careful not to overdo it, as it could lead to a loss of profits in the long run.