Diversification is an investment strategy that combines a wide variety of investments in a portfolio to reduce risks associated with investing.
By combining different kinds of assets in a portfolio, an investor can limit exposure to the risks associated with investing in a single asset.
Understanding Investment Diversification
When an investor gets different types of assets and investment vehicles in their portfolio, the diversification process smoothens any risks from a single security.
The positive performances of some securities will balance out the negative performance of others, reducing the overall risk of investments.
Types of Investments
Investors building a diversified portfolio can invest in various stocks and securities, like the following:
You can invest in various asset classes:
- Stocks. Shares or equity of a public company;
- Bonds. Fixed-income debt instruments like government or corporate bonds;
- Cash and Cash Equivalents. Short-term low-risk investments like certificates of deposits (CDs), treasury bills, and other short-term money market instruments;
- Real Estate. Can be in the form of land, building, agriculture, livestock, or others;
- Commodities. Goods necessary to manufacture other goods and services like gold, crude oil, and more;
- ETFs. Marketable collection of securities traded on a stock exchange.
Industries and Sectors
You can diversify your portfolio by investing in stocks and bonds of companies in different industries and sectors like energy, healthcare, and technology. Growth in one sector can fuel its share prices, balancing a fall in other industries while diversifying the investor's portfolio.
Domestic and Foreign Countries
Diversification is also possible by investing in domestic and international shares. In addition, investing in different global markets can diversify portfolios.
To effectively diversify a portfolio, investors need to have a balanced mix of different types of securities that are not perfectly co-related; that is, they respond differently to changes in market conditions.
Investors can diversify their portfolios by investing in different types of shares following the strategies mentioned below.
Investors often diversify portfolios based on the different asset classes.
Stocks and Bonds
Stocks and bonds represent two leading asset classes. Therefore, one strategy to diversify a portfolio is determining the proportion of investment between stocks and bonds.
Although stocks often offer higher returns, they tend to be riskier than bonds. In contrast, bonds offer a secure way of investing with lower returns.
Bond Assets Classes
Bonds can be classified based on the following:
- Credit risk. It represents the borrower's risk. For instance, U.S Treasury bonds tend to have the least risk of default;
- Interest rate risk. It represents the time required for the bonds to mature. Bonds with longer maturity periods, like 30-year bonds, have a higher interest rate risk when compared to short-term bonds.
Alternative assets, like real estate, cryptocurrencies, and commodities, do not fit into the stock and bonds asset classes. Therefore, investing in them can further diversify the investor's portfolio.
Industries and Sectors
Investors can diversify their portfolios by investing in different industries and sectors. For example, investing in unrelated industries like airlines and digital streaming can help hedge the risks of investing in a particular industry or sector.
Geographical Locations (Domestic vs. Foreign)
Investing in foreign securities can help investors diversify their investments. Geographical locations typically classify as U.S. companies, companies in developed countries, and those in emerging markets.
Investors looking to benefit from higher growth potential and high risks can invest in emerging markets.
Market Capitalizations (Big vs. Small)
Another way investors can diversify is by purchasing shares in companies that differ in the market capitalization of their assets.
Companies have a unique way of asset acquisition, brand recognition, and other operations based on their market size. While large capital stocks are considered safe investments, small caps have more significant growth potential.
Company Lifecycle (Growth vs. Value)
Public equity shares can classify into growth and value shares.
- Growth stocks. These are shares with the potential to experience a higher growth rate than the industry average. They offer excellent returns but can be risky.
- Value stocks. These shares have reached their growth potential and offer a stable form of investment, although the returns are not as high.
By investing in a balanced way between the two shares, an investor can further diversify their portfolio.
Benefits and Limitations
Investment diversification does have its advantages and drawbacks.
One of the most significant benefits of diversification is reducing your risk. If one asset class isn't performing well, another asset class can make up for it. In addition, it can help you achieve your long-term financial goals by mitigating risk.
Diversification can limit some downsides by averaging volatility and risk across a group of investments. However, it can shorten your upside, causing you to realize lower rewards. As you further diversify your portfolio, your returns may mimic the market average. A highly diversified portfolio can be time-consuming if you're doing it alone.
Investment diversification is an essential strategy in financial and investment planning and management. Instead of putting all your money in a single asset, maintaining a diverse pool of assets can balance your risks while ensuring an optimum return on investments.