Diversification

Broaden Your Horizons

Safety in Numbers

All investing carries risk, but there is one major way you can reduce risk for your entire portfolio: diversification.

While thorough due diligence is a crucial part of successful investing, diversifying your portfolio across many different asset classes and individual securities can help reduce the chances that you lose money on all of your investments at once.

How it works

The idea behind diversification is this: If one investment you own falls significantly in value, your other investments may fall less, hold their values, or even gain in price. The more you spread your bets, the less likely it should be that a bump in the market tanks your whole portfolio and the smoother your overall returns should be.

Diversification works because investments don’t all move in lockstep. During some years, tech stocks may soar while oil stocks lag. In oth`er years, stocks of large companies may perform well while shares of small companies struggle. By spreading your bets widely, you don’t have to guess which investment type will be the best or worst performer in a given year—you can just hold a bit of everything.

Diversification in action

Consider two portfolios: One is invested 100% in Stock A, while the other holds a small position in Stock A plus stakes in other stocks, bonds, and real estate.

If Stock A suddenly suffers a 50% drop, the portfolio that only holds Stock A will also suffer a 50% drop. By contrast, the diversified portfolio will only lose a small amount (assuming the portfolio’s other investments hold their value).

Investment risk can never be fully eliminated, but broad diversification can help mitigate it.

Double down

There are two main ways of diversifying. The first is to divide your portfolio across different categories of investments, or asset classes, such as:

  • Stocks
  • Bonds
  • Cash
  • Real estate
  • Alternatives

How you divide your money between asset classes is called your asset allocation, and determining your optimal asset allocation is about risk tolerance. Certain asset classes, such as stocks, are riskier than others, such as bonds. So the asset allocation that’s best for you typically depends on the amount of risk you want to take on.

However, just because you want a portfolio that’s 60% stocks doesn’t mean that 60% should be invested in a single security. Instead, that portion of your portfolio should be spread across many different stocks—including companies of different sizes, different industries, or even different countries.Ways of diversifying within asset classesWays of diversifying within asset classes

  • Ways of diversifying within asset classes
    • Stocks
      • Company size
      • Industry
      • Geography
    • Bonds
      • Corporate vs. government
      • Domestic vs. international
      • Short term vs. long term
      • High credit quality vs. low credit quality
    • Real estate
      • Property type
      • Geography

      Combining prudent asset allocation with broad diversification can mean a better chance of weathering economic storms—if your tech stocks take a tumble, your international bonds may still provide consistent returns.

      Conclusion

      Diversification is an important part of smart investing. By spreading your eggs across many different investment baskets, you can reduce your portfolio’s risk and even boost its returns. That said, not all diversifying investments are great investments—a portfolio of 1,000 lottery tickets might be well-diversified, but it wouldn’t be a smart investment. You should always still have a solid reason for holding any investments you own.

      Key takeaways

      Diversification is a way to limit your portfolio’s risk by investing in a broad range of assets.
      Diversification reduces the likelihood that all your investments will lose value at once and can smooth your portfolio’s returns.
      You can diversify by investing in different asset classes, such as stocks, bonds, and real estate.
      You can also diversify by investing in different securities within each asset class—such as by holding stocks in different industries and bonds from different issuer types.
      Don’t buy risky products just because you want to diversify.

      Fun facts

      • Diversification is sometimes called “the only free lunch” in investing because it can reduce risk without sacrificing returns.
      • In addition to traditional stocks, bonds, and real estate, some people choose to diversify with cryptocurrencies, peer-to-peer loans, and foreign currencies.
      • Very wealthy investors sometimes diversify with racehorses, liquor companies, and football teams.

       

      References

      1. https://www.sec.gov/investor/pubs/assetallocation.htm
      2. http://www.investopedia.com/terms/d/diversification.asp
      3. http://www.investopedia.com/articles/02/111502.asp
      4. http://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2013/05/31/heres-why-diversification-matters
      5. http://www.investopedia.com/articles/basics/05/diversification.asp
      6. http://finance.zacks.com/portfolio-diversification-theory-6684.html
      7. https://en.wikipedia.org/wiki/Harry_Markowitz
      8. https://en.wiktionary.org/wiki/diversification

You May Also Like