Diversification is an important strategy for investors of all skill levels. Not putting all your eggs in one basket is the basic concept of diversification. The strategy spreads your money across multiple investments and industries, so your portfolio is protected if one asset takes a loss.
Diversification is important to minimize your exposure to volatile market conditions. Additionally, diversification goes beyond your stocks. You can diversify all asset classes to reduce your risk.
Why Is Diversification Important?
As an investor, your goal is to improve your wealth for your personal goals, both long and short. Diversification allows you to manage the risks within your portfolio.
By properly weighting your portfolio, you will not rely heavily on one sector or company. This protects you in case of volatility within the industry or a catastrophic loss of capital if the company does not perform as you predicted.
What Are the Components of Diversification?
The components of diversification cross many asset classes. You should consider each when making your investments. Within each asset class, there are many variables, all with varying levels of risk. Diversification can mitigate the risk of the more volatile investments, although it does not guarantee that your portfolio will never see a loss.
Domestic & International Stocks
Stocks are typically the most aggressive portion within an investor’s portfolio. They provide higher growth over time, but they come with higher risks than other short-term investments.
Because stocks are more volatile, you can diversify your investments between both domestic and international stocks. You can also invest in multiple industries, sectors, and across businesses of varying sizes to help manage your risk.
Bonds have modest returns compared to stocks. Investors lend money to a company or government entity and in return receive interest payments. You can diversify the bonds in your portfolio to include both public companies and local and federal government entities.
Certificates Deposits & Money Market Funds
Short-term investments like CDs (certificates of deposit) and money market funds are another asset class you should consider diversifying. While they are considered one of the most conservative investment vehicles, they provide investors easy access to their money and offer stability, which can be vital as you get closer to retirement.
Real Estate Funds
Real estate investment trust funds (REITs) are another great way to diversify your portfolio. They are a type of mutual fund that is focused on investing in real estate companies that are publicly traded. A REIT is an income-producing property that is traded similarly to a stock. Both can help increase your wealth.
Benefits of Diversification
Diversification is an important strategy to reduce your unsystematic risk (the risk that comes from investing in specific companies and industries).
The important thing to remember about diversification is that it is not a strategy that will maximize your returns. Instead, its focus is to limit volatility on your portfolio. It will not entirely eliminate your risk, but it can drastically reduce asset-specific risks.
Grants More Opportunities for Return
The longer you have a diversified portfolio, the more opportunities you have for increased long-term returns. In fact, diversified portfolios typically have higher returns over an extended period of time.
Protects You From Market Volatility
Market volatility is part of investing. The constant price changes are required in order for investors to make a profit. But the market does not always go in your favor. When you diversify your investments, you can minimize the risk of loss when the market turns.
For example, if you are investing only in the energy sector in oil and gas companies, or other consumable fuels, you are leaving yourself at risk. This market sector tends to follow closely with the price of crude oil. If the price goes up, your entire portfolio would as well. But if the price dropped, your portfolio would follow suit. Diversifying across multiple assets, market sectors, and industries can help protect you from market volatility.
Downsides of Diversification
The purpose of diversification is to manage your risk, but before doing so you should consider the negatives before taking on the task.
The more you invest in various companies, the more you run the risk of investing in companies that are of quality. Not all publicly traded companies are good investments, and if you invest in the wrong ones, you will not be making the right investment decision.
Can Be Complex
Diversification takes time and knowledge. It can be a complex strategy for an average trader. If you overcomplicate the process, it will not be easy to stay on top of your investments.
Below Average Returns
If you own inferior investment, as mentioned above about quality, you will see below average returns. These sub-par investments could technically “diversify” your portfolio but provide a lower return that makes your portfolio suffer.
Lack of Focus & Potential Bad Investment Vehicles
The complex diversification process has many investors turning to advisors to manage their portfolio. If someone else is handling your investments, you might not be paying as close of attention as you should and might not notice an issue until it is too late to make adjustments without a major loss.
Portfolio volatility can cause investors to achieve even average returns. If you over diversify your portfolio, you run the risk of seeing lower portfolio performance across the board.
Tips to Succeed With Diversification Strategy
An important thing to look at as you consider diversification is that if you invest in too many assets in your portfolio, you essentially create an index fund. At that point, you likely would have been better off buying an index fund and avoiding transaction fees.
However, with proper diversification, you can improve your portfolio’s performance and mitigate risks.
Spread Your Wealth
When you are building your portfolio, you should not focus your money on one stock or sector. Instead, invest in companies that you trust across multiple industries. You should also do this with other asset classes like REITs and bonds.
Look Into All Options
It might be worth adding an index fund to your portfolio. They are an investment vehicle that provides diversification across multiple index classes that are meant to match the performance of the indexes.
Keep Adding to Your Portfolio
If you invest on an average basis, you can avoid the peaks and valleys of market volatility. The concept behind continually investing is that you cut your investment risk by making recurring investments over time.
Know When It is Time to Get Out
Some investors like to be passive, and that’s ok. But even if you have your investments set on autopilot, you should continue to stay current of market conditions and your portfolio. Knowing when you cut your losses is important to help improve your overall wealth.
Asset Allocation vs Diversification
Diversification is the next strategy you should employ after asset allocation. When you allocate your assets, you invest in multiple asset classes to minimize your portfolio’s risk. With diversification, you take the risk management one step further by spreading your investments in each asset class.
When you balance your portfolio with asset allocation and diversification, the two strategies can potentially reduce the volatility over time, providing comfortable, steady returns.
Diversification Has Long-Term Value
A well-diversified portfolio can help you manage risks while still seeing substantial growth. Even better, you do not have to go it alone.
Your financial advisor has diversification strategies that can not only help minimize your risks, but also help you reach your goals. Working with them can give you peace of mind to ensure your portfolio is performing as it should.