Why is It Better to Have a Diversified Investment Portfolio?
Equirus Wealth
05 Dec 2022 • 6 min read
Visualize you purchasing Microsoft Corporation (MSFT) as your sole investment. Since MSFT is a technology company, your asset allocation would consist entirely of equity in the market's technology sector. Even if you diversify your holdings within the technology sector by purchasing shares of other tech companies, your portfolio would still suffer significantly if the entire industry experiences a downturn. So, diversification in various assets is essential.
What do you understand by "Diversification"?
Diversification is a technique used in economics to lower risk by allocating investments among different financial businesses and other instruments. Investment diversification primarily aims to maximize returns by investing in various sectors that respond differently to the same event.
- Diversification reduces the number of unsystematic risks.
- The high cost and complexity of managing diverse portfolios result in lesser returns because the chances are reduced.
What are the Components of a Diversified Portfolio?
Your portfolio should have two or more of the following asset components:
- Stocks give investors access to the largest, most liquid equity market in the world and give you a chance to purchase some of the top firms in the world.
- Several bonds provide consistent interest income and are typically seen as less volatile than equities.
- Cash is the money you have in your pocket, savings account, or under your pillow. Cash is low risk and low reward in both categories. Unexpected costs or volatility can be absorbed by cash.
- Other asset groups include real estate (property), commodities (natural resources, precious metals), and alternative investments. These asset types might be helpful for diversification as they often have weaker correlations to the stock market.
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Types of Portfolio Diversification
1. Asset class diversification: Spreading investments across different asset classes like stocks, bonds, real estate, and commodities as each asset class has a different risk and return characteristics.
2. Industry diversification: Allocating investments across various industries such as technology, healthcare, finance, and consumer goods to mitigate risks associated with a specific industry.
3. Geographic diversification: Investing in different regions or countries to reduce exposure to risks associated with a particular country or region.
4. Time diversification: Spreading investments over different time periods to take advantage of market cycles and reduce the impact of market volatility.
5. Alternative asset diversification: Including non-traditional assets such as hedge funds, private equity, commodities, and real estate to further diversify the portfolio.
6. Risk diversification: Diversifying investments across securities with varying risk levels reduces the overall risk of a portfolio.
Why should you have a Diversified Portfolio?
There are various benefits of having a Diversified Portfolio:
Reduce Investment Risk
Sorting assets into several categories can help lower portfolio loss risks.
- Systematic Risk
These risks come along with owning any asset, including money. The market may become less appealing for all purchases due to changes in interest rates, investor preferences, or other events like a war or terrible weather.
- Asset Specific Risk
The assets or businesses themselves cause unsystematic (asset-specific) risks. These dangers include management's performance, the stock price, and the success of a company's products. Through diversification, the asset-specific risk in your investment portfolio can be significantly decreased. Diversification does not, however, ultimately mitigate market risk.
Statistical Advantage
Statistics have shown that a portfolio with various assets performs better than one that is all or nothing in one specific support, which is one reason a diversified portfolio makes sense. It's one strategy that enables you to benefit by obtaining something rather than a lot.
Volatility
A diverse portfolio aids in preventing significant price changes depending on the asset, which can cause things like panic and stress. This diversification is comparable to risk minimization. Balancing volatile and nonvolatile holdings in your portfolio can lessen price swings and enjoy greater peace of mind.
Capital Preservation
A diverse portfolio will help you preserve and retain your investment by protecting you against risk and volatility. Preservation is occasionally the best strategy for maintaining success in your portfolio. And if you don't have any assets in your portfolio, you can't earn any money.
Correlation
The amount and direction of the relationship between the returns on two assets are measured by correlation. When two assets correlate, they move precisely in the same direction, and when they move perfectly in opposite directions, the correlation is 1. Two assets move when there is no tie between them.
Standard Deviation
The historical range that an asset fluctuates, on average, around its expected return is captured by standard deviation and variance. As a general rule, a diversified portfolio of uncorrelated assets with positive anticipated returns that are volatile (high standard deviation) and uncorrelated (between 0.20 and 0.50) will generate a better risk-return profile than an undiversified portfolio made up of just one asset.
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How should you Diversify your Portfolio?
Whether you wish to start investing or have experience and want to do diversification, you should follow these factors.
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The share price, foreign currency rates, and property worth of a corporation are not all impacted by market developments in the same way. So, make several investments.
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One prevalent misconception is that diversification invests in many businesses, regardless of their operating industries. Invest in a range of industries.
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Because economic ups and downs typically don't have an equal impact on all nations, investing in several areas can help you limit risk, just like investing in various products and industries.
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You must consider your own liquidity needs and expectations even if spreading maturity lengths helps to lessen risk.
Final Thoughts
Creating a diversification strategy for your portfolio may seem complicated, especially if you don't have the time, expertise, or desire to investigate specific stocks or decide whether buying a company's bonds makes sense. You can buy most securities separately or in groups, such as through mutual funds, index funds, or exchange-traded funds (ETF).
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