What Is Diversification?
In investing, diversification involves spreading your money around among multiple investments to limit your exposure to any one investment. The practice can reduce the volatility of your portfolio because when one asset is falling, others may be rising, offsetting some of the losses on the declining asset. Diversifying your portfolio helps balance risk and reward in your investments.
4 Types of Diversification Strategies
There are a few different ways to diversify your portfolio:
1. Asset Diversification
The first way to diversify is by investing in multiple kinds of assets; for example, a mix of stocks, bonds, cryptocurrency, commodities, real estate, and gold or other precious metals.
2. Position Diversification
In addition to diversifying among multiple types of assets, it's also usually a good idea to diversify within those asset classes. For example, an investor can add diversification within a portfolio of stocks by selecting individual companies from different sectors. Sometimes it might seem like all stocks are going up, or all are declining, but that's not necessarily the case. Usually, large numbers of stocks are rising and falling on the same trading day.
Investors might also benefit from a portfolio of bonds from different companies.
3. Geographic Diversification
Another way to diversify is to invest in different geographies. For example, an investor could allocate a percentage of their portfolio to developed markets and another percentage to emerging markets. Many investors have direct exposures to investments in the U.S., Europe, China, and other countries, gaining exposure to different parts of the world.
4. Company Size Diversification
It may also be a good idea to diversify among companies of different sizes, or market capitalizations. Sometimes large-cap companies do better than small caps, and vice versa.
Tip: Portfolio diversification involves spreading your money around among multiple investments. Diversification can include spreading investment dollars among various assets types, specific companies, and geographies,
Advantages of Diversification
If you're wondering why diversification is important in an investment portfolio, there are several reasons.
1. Minimizes Risk
Perhaps the most important benefit is the fact that, if done correctly, it can minimize the risk that you will lose money in your portfolio without reducing expected return. When one asset class or position is falling sharply, hopefully, other positions in a portfolio are rising, flat, or at least declining less. Diversification can thus assist in protecting your wealth.
2. Increases Opportunity for Returns
Spreading your investment dollars among different investment positions can also increase the opportunities for returns. If investors put all their eggs in one basket, that one investment may not deliver any profits or even lose money. However, selecting a larger number of investments increases the probability that one or more see nice gains. In addition, perspective losses from a stock that declines one month can be offset by another that rises.
3. Protects Portfolio During Market Cycle Changes
Diversification can also protect a portfolio when the market shifts into another stage of the market cycle. For example, investors could allocate some of their portfolios into sectors that are out of favor, preparing them for when that sector will rebound. The cycle can shift suddenly without warning, so by owning sectors that are and aren't doing well, you prepare your portfolio for that shift. The sector that was losing money may start posting positive returns after the cycle shifts.
4. Reduces Portfolio Volatility
You also reduce volatility in your portfolio by owning a variety of assets. As already stated, it's a good idea to own a variety of different stocks, bonds or sectors because when one starts to rise, another may reverse. When you look at your portfolio as a whole, it's less volatile because the different positions are offsetting each other.
Disadvantages of Diversification
While diversification is usually recommended, there are some possible drawbacks.
1. Can Be Complicated
Determining what percentage of your portfolio to allocate to what type of asset may require a bit of research and management effort on your part. Managing a diversified portfolio can also be time-consuming for those without a lot of experience investing.
2. Can Limit Upswings
Diversification can also limit the upside of your portfolio while protecting it from excessive amounts of downside. A portfolio of one stock could see huge gains if that one position soars in value. By diversifying, positions that are delivering substantial profits will be subdued by some positions that are not.
3. Can Contain Very Risky Individual Investments
Additionally, even though diversification is a strategy to reduce risk, some investors may be more prone to buying some very risky individual investments that they may not understand, within a diversified portfolio.
4. Potential for High Transaction Costs
Transaction costs on a widely diversified portfolio can be higher if it results in you making a lot of trades instead of buying and holding the positions you have.
5. Doesn't Guarantee Protection From Market Swings
Finally, diversification doesn't always protect you from the market's ups and downs. For example, during the Global Financial Crisis in 2008 and 2009, almost every stock fell significantly, so diversifying by owning a wide array of different stocks didn't help much.
Tip: The number one benefit of diversification is that it can reduce volatility in a portfolio, but on the other hand, it might also reduce overall returns.
Examples of Diversification
Here's an example of a diversification strategy. An investor might want to put 60% of your portfolio in stocks and 40% in bonds. To diversify the stock holdings, the investor might want to hold 20 different stocks across multiple sectors.
Another example of diversification is to invest 40% of a portfolio in stocks, 20% in bonds, 10% in real estate, 5% in cryptocurrency, 20% in commodities and 5% in cash or foreign currencies. Investors could also think to consider investing 50% of their portfolio in the U.S., 25% in other developed markets, and 25% in emerging markets.
How Should You Diversify Your Portfolio?
Diversification is almost universal advice for investors, but that doesn't mean investors should always default to adding diversification. Research has shown that as diversification increases, the benefit of that additional diversification grows smaller. For example, diversifying a stock portfolio from 1 stock to 21 stocks may add substantial diversification benefits. Diversifying a stock portfolio from 101 stocks to 121 stocks won't usually provide as much incremental diversification benefit. Heavily diversified portfolios may also lead to greater portfolio management complexity.
If an investor is worried about risk as the market moves through its current cycle, it's usually best to consider some level of diversification. After all, diversification removes some of the volatility from your portfolio, which might also lower an investor's stress level about their portfolio. Diversification could result in lower portfolio returns if a particular investor makes poor decisions about where to specifically place those diversified investments. For example, if an investor has a high confidence in 5 specific stocks, and low confidence in all other stocks, diversifying beyond those 5 stocks could potentially do more harm than good.
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