Defining diversification
In order to lower the risk of market volatility, investors frequently use the investment strategy of diversification, in which they distribute their portfolio among a variety of securities and asset classes. It is a component of asset allocation, which refers to how much of a portfolio is invested in different asset types. Stocks, bonds, and cash are three of the most popular asset classes (or cash equivalents). Investors will combine disparate assets to achieve diversification so that their portfolio does not have an excessive amount of exposure to one particular asset class or market segment.
There are numerous investment alternatives available to investors, each with unique benefits and drawbacks. Diversifying your portfolio by asset class, within asset classes, and outside of asset classes are some of the most popular methods.
Is diversification important?
Diversification offers what experts refer to as a "free lunch" because it lowers overall risk while raising the possibility of total return. This is due to the fact that some assets will perform well while others will not. However, their rankings could change the following year, with the previous losers rising to the top. No matter which stocks perform well, a well-diversified stock portfolio often generates the market's long-term historical average return. However, that return might fluctuate greatly over brief timeframes.
The chart from J.P. Morgan below displays the variability of various investment kinds from 2004 to 2018. The "asset allocation portfolio" (a diversified portfolio with a mix of investments) stays in the middle of the pack while navigating the market's unpredictability, earning an annualized return of 6.2% for the time period and leveling the ride.
Having a diverse portfolio reduces the likelihood that any one asset may harm it. The cost of this is that you can never fully reap the astonishing benefits of a shooting star. The overall result of diversification is slower, more consistent performance and smoother returns that never rise or fall abruptly. Many investors feel more at peace because of the decreased volatility.
How diversification can benefit you
One of the biggest advantages of diversification for you as an investor is that it can actually increase your prospective profits and stabilize your outcomes. You lower the total risk of your portfolio by owning a variety of assets with diverse performances so that no one investment may really harm you. This "free lunch" is what really appeals to investors about diversity.
There are three primary strategies for portfolio diversification, and a wise portfolio manager considers all three....3 Strategies for Portfolio Diversification
- Individual Asset Diversification. ...
- International Market Diversification. ...
- Asset Class Diversification.
Because investments behave differently during various economic cycles, diversification helps you get more consistent returns. Bonds may be zigging while equities are zagging, and CDs are simply expanding slowly.
In actuality, you end up with a weighted average of the returns from the assets by owning different proportions of each asset. You won't experience its ups and downs, but you also won't get stunningly high profits from owning just one rocket-ship stock.
Diversification can lower risk, but it cannot completely remove it. The risk of holding an excessive amount of a single stock, such as Amazon, or stocks in general, as compared to other investments, is decreased through diversification. It does not, however, eliminate market risk, which is the risk associated with even having that kind of asset.
Diversification, for instance, might reduce the amount your portfolio drops if some stocks slump, but it can't shield you if investors decide they don't like stocks and punish the entire asset class.
Diversification can help protect you from a problem at a particular company when dealing with interest rate-sensitive assets like bonds, but it won't shield you from the possibility of rising rates generally.
Inflation threatens even cash and investments like CDs and high-yield savings accounts, despite the fact that deposits are normally insured against principal loss up to $250,000 per account type per bank.
Therefore, diversification is effective in mitigating asset-specific risk but ineffective in combating market-specific risk.
Strategizing your diversification
There are many tactics to use as investors think of methods to diversify their holdings. In order to increase the degree of diversification within a single portfolio, many of the strategies listed below can be combined.
Asset Types
When deciding how much of the portfolio to devote to each asset class, fund managers and investors frequently diversify their holdings across different asset classes. Each asset class has its own distinct mix of opportunities and risks. Some classes include:
- Stocks—shares or equity in a publicly traded company
- Bonds—government and corporate fixed-income debt instruments
- Real estate—land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
- Exchange-traded funds (ETFs)—a marketable basket of securities that follow an index, commodity, or sector
- Commodities—basic goods necessary for the production of other products or services
- Cash and short-term cash-equivalents (CCE)—Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments
According to the notion, something that can be advantageous for one asset class might be detrimental to another. For instance, increasing yield is required to make fixed-income instruments more desirable, hence rising interest rates often have a negative influence on bond prices. On the other hand, increasing interest rates could lead to higher prices for commodities or higher real estate rent.
Industries/Sectors
The ways that various industries or sectors function vary greatly. Investors are less likely to be influenced by sector-specific risk if they diversify across many businesses.
CHIPS and Science Act of 2022
Although many different industries are impacted by this piece of legislation, some businesses are more negatively affected than others. The financial services industry may experience minor, residual effects, whereas semiconductor manufacturers may be significantly impacted.
By combining investments that may counterbalance several enterprises, investors can diversify across industries. Think about two popular forms of entertainment, streaming online and vacation. Investors in digital streaming services may do so in order to protect themselves from the possibility of future severe pandemic effects (i.e. positively impacted by shutdowns). Investors may think about simultaneously investing in airlines (positively impacted by fewer shutdowns). These two unconnected industries might theoretically reduce the overall risk of a portfolio.
How many stocks should you own to adequately diversify your portfolio? There are simply too many factors to take into account, according to a study that was published in the Journal of Risk and Financial Management, and "an ideal number of companies that compose a well-diversified portfolio does not exist."
Stages of the Corporate Lifecycle (Growth vs. Value)
Growth stocks and value stocks are the two main divisions of public equities. Growth stocks are shares of firms that are anticipated to generate higher-than-average growth in sales or profit. Value stocks are shares of firms that, based on their current financial fundamentals, appear to be trading at a discount.
Growth stocks are typically riskier because a company's anticipated growth might not occur. For instance, if the Federal Reserve tightens monetary policy, less cash is often accessible (or borrowing money is more expensive), making the situation for growth enterprises more challenging. Growth businesses, however, might unlock this seemingly endless potential, go above and beyond, and produce even higher profits than anticipated.
Value stocks, on the other hand, typically represent more mature, reliable businesses. Even though they might have already reached the majority of their potential, these businesses typically pose fewer risks. An investor that diversifies into both would benefit from the current advantages of some companies as well as the potential of others in the future.
Capitalizations of the Market (Large vs. Small)
Based on the underlying market capitalization of the asset or firm, investors might want to think about spreading their money over a variety of assets. Think about how much the operational approaches of Apple and Embecta Corporation differ. Both businesses are members of the S&P 500 as of August 2022, with Apple accounting for 7.3% of the index and Embecta for.000005%.
Each of the two businesses will take a very different approach to raise money, launching new goods onto the market, building brand recognition, and maximizing growth potential. In general, lesser-cap equities have more potential for growth, despite the fact that higher company stocks typically make for safer investments.
Profiles of Risk
Investors can select the security's underlying risk profile across practically all asset classes. Take fixed-income securities, for instance. Investors have the option of purchasing bonds from the world's top-rated countries or from virtually bankrupt private enterprises that are raising emergency cash. Several 10-year bonds have significant changes depending on the issuer, their credit rating, their expectation for future operations, and their current level of debt.
The same is true of other investment types. Compared to existing, operational properties, real estate development projects with greater risk may provide greater upside. In contrast, compared to coins or tokens with smaller market caps, cryptocurrencies with longer histories and wider popularity, like Bitcoin, bear less risk.
Diversification may not be the most effective course of action for investors looking to optimize their returns. Think about "YOLO" (you only live once) techniques, in which all of your money is invested in a high-risk venture. Even if there is a bigger likelihood of generating money that can change your life, there is also a higher likelihood of losing money as a result of inadequate diversification.
Lengths of Maturity
Particularly with regard to fixed-income products like bonds, various term lengths have an impact on various risk profiles. In general, the risk of price swings brought on by changes in interest rates increases with bond maturities. Although short-term bonds often have lower interest rates, they are also less susceptible to the unpredictability of future yield curves. Longer term bonds that typically pay greater rates of interest may be added by investors who are more risk-averse.
Other asset classes also frequently use maturity duration. Think about the distinction between long-term lease agreements for commercial properties and short-term lease agreements for residential properties (i.e., up to one year) (i.e. sometimes five years or greater). Long-term leases boost the certainty of collecting rent payments, but also limit an investor's ability to raise rents or switch tenants.
Physical Places (Foreign vs. Domestic)
By purchasing foreign assets, investors can profit even more from diversification. For instance, factors affecting the U.S. economy may not have the same impact on Japan's economy. Therefore, owning Japanese equities provides a minimal level of loss protection during a downturn in the American economy.
Alternately, diversifying among developed and emerging nations may offer greater potential gain (with corresponding higher degrees of risk). Think about Pakistan's existing status as a participant in the frontier market (recently downgraded from an emerging market participant). 4 Investors ready to assume greater levels of risk might want to take into account the greater development potential of smaller, less developed markets like Pakistan.
Tangibility
Stocks and bonds are examples of financial assets that are intangible investments since they cannot be seen, touched, or felt. Contrarily, tangible investments may be handled and have practical uses, such as real estate, farmland, precious metals, and commodities. These tangible assets have different investment profiles than intangible or digital ones since they can be used, rented out, developed on, or otherwise handled differently.
Furthermore, tangible assets have particular hazards that are distinct. Real estate is susceptible to vandalism, physical theft, natural disaster damage, and obsolescence. Real assets could also need to pay for storage, insurance, or security expenses. Although the revenue stream differs from that of financial instruments, so do the input expenses involved in safeguarding tangible assets.
How to develop a diversification strategy
Now that low-cost mutual funds and ETFs are available, building a well-diversified portfolio is actually quite easy. These funds are not only inexpensive but many of them can now be traded at no cost through major brokerages, making it very simple to enter the market.
Holding a substantially diversified index fund, such as one based on the Standard & Poor's 500 index, which owns holdings in hundreds of companies, might constitute a basic diversified portfolio. To stabilize the portfolio, though, you'll likely also want some exposure to bonds, and CDs that offer guaranteed returns are also helpful. Finally, having money in a savings account will help you maintain your stability and provide you with emergency cash if necessary.
You can diversify your stock and bond assets if you wish to go beyond this fundamental strategy. For instance, since an S&P 500 fund doesn't own companies in emerging countries or international companies in general, you may add a fund that does. A fund made up of tiny public companies is another option as it is not included in the S&P 500.
To get exposure to both and a better return on the longer-dated bonds, you can consider bond funds that include both short- and medium-term bonds. You can build a CD ladder for CDs to provide you exposure to interest rates over time.
To further diversify beyond conventional assets like equities and bonds, some financial advisors even advise their clients to think about including commodities like gold or silver in their portfolios.
Finally, regardless of how you build your portfolio, you want to find assets that behave differently depending on the state of the economy. The fact that many funds that own the same large stocks will perform largely indistinguishably over time negates the benefit of diversity.
Additionally, a fund or a robo-advisor can handle it for you if it all sounds like too much work. As you come closer to a target year in the future, usually your retirement date, a target-date fund will gradually shift your assets from higher-return assets (stocks) to lower-risk ones (bonds).
Similar to this, a robo-advisor might set up a diversified portfolio to achieve a particular objective or deadline. However, you'll probably pay more than if you did it yourself in any situation.
Diversification – Pros and Cons
Diversification is mostly used to reduce risk. You are less likely to face market shocks that equally affect all of your investments by diversifying your investments among several asset classes, industries, or maturities.
There are further advantages as well. Diversification may inspire investors to explore new, interesting investments, which some investors may feel makes investing more enjoyable. The likelihood of receiving good news may also rise as a result of diversification. Positive news affecting one of the dozens of companies may be advantageous to your portfolio instead of hoping for good news unique to one company.
However, diversification also has disadvantages. A portfolio can be more time-consuming to manage and more expensive as it becomes more expensive to buy and sell a variety of holdings due to higher transaction costs and brokerage commissions. Fundamentally, diversification lowers both the risk and the profit by using a spreading-out method.
Let's imagine that you split your $120,000 among six equities, and one of them doubles in value. Your initial stake of $20,000 is now worth $40,000 in total. Sure, you've made a lot, but not as much as if you'd put your entire $120,000 into that one business. Diversification restricts your upward potential while safeguarding your downside—at least temporarily. Diversified portfolios do typically produce superior returns over the long term.
To summarize:
Pros
- Reduces portfolio risk
- Hedges against market volatility
- Offers potentially higher returns long-term
- It may be more enjoyable for investors to research new investments
Cons
- Limits gains short-term
- Time-consuming to manage
- Incurs more transaction fees, commissions
- It may be overwhelming for newer, inexperienced investors
Risks of diversification
Although diversity is a simple strategy for lowering risk in your portfolio, it cannot completely remove it. Investment risk can be divided into two categories:
- Systemic risk (market risk): These dangers are inherent in holding any asset, even cash. Due to changes in interest rates, investor preferences, or other factors like a war or bad weather, the market may become less desirable for all assets.
- Risks unique to an asset (unsystematic risk): These dangers stem from the businesses or investments themselves. These dangers include the performance of management, the price of the stock, and the success of a company's products.
By diversifying your investments, you can significantly lower asset-specific risk. But no matter what you do, diversification cannot completely eliminate market risk. It's a universal truth.
Stockpiling businesses in a single market or industry will not provide the benefits of diversification and may even increase risk. How awful would it have been to have a portfolio made up entirely of banks during the global financial crisis? But other investors did, suffering from stomach-churning outcomes that kept them up at night. A portfolio needs a diverse range of industries since the risks faced by the businesses within each area are similar. Keep in mind that portfolios must differ by firm industry, size, and geography to lessen company-specific risk.
FAQ
What does a good investment portfolio look like?
A wide variety of investments should be included in a diversified portfolio. For many years, financial consultants frequently advised creating a 60/40 portfolio, in which 60% of the capital would be invested in equities and 40% would be in fixed-income securities like bonds. Others, notably younger investors, have urged for greater equity exposure.
What are the 5 types of portfolios?
The 5 types of portfolios are:
- The Aggressive Portfolio.
- The Defensive Portfolio.
- The Income Portfolio.
- The Speculative Portfolio.
- The Hybrid Portfolio.
What is a good return on your stock portfolio?
Generally speaking, a yearly ROI of around 7% or higher is regarded as a decent ROI for an investment in stocks. This also refers to the S&P 500's average annual return when inflation is taken into account. Due to the fact that this is an average, your return may vary from year to year.
What are the three main ways to diversify your portfolio?
A sage portfolio manager takes into account all three of the main methods for portfolio diversification:
- Individual Asset Diversification.
- International Market Diversification.
- Asset Class Diversification.
How much is too diversified?
There is no clear line that separates a portfolio that is sufficiently diversified from one that is overly diverse. Most investors would consider a portfolio that has 20 to 30 investments spread across multiple stock market sectors to be appropriately diversified.