Diversification is a risk management strategy that involves combining a wide range of investments within a portfolio. A diversified portfolio will include a range of different investment vehicles to help limit the exposure to any single asset or risk.
Aside from asset class diversification, portfolios can be diversified by investing in both foreign and domestic markets. While diversification limits portfolio risk, it is often considered to also affect portfolio performance, if only in the short term.
How Diversification Works
Diversification works by building a portfolio that contains a variety of asset types, investment vehicles and includes investment in both domestic and foreign markets to lower the risk of any individual holding or security. An investor might also choose to diversify within equities by investing across a variety of sectors and geographies.
While in the short-term the performance of a diversified portfolio may be impacted, on average diversification helps portfolios perform better and yield higher long-term returns. The principle of diversification is that the positive performance of one area of a portfolio will outweigh the negatives in other areas.
Studies and mathematical models have shown that diversification can help investors achieve the most cost-effecting level of risk reduction. For true diversification, investors should invest in securities that respond differently to market influences.
Types of Diversification
The different types of diversification include:
By Asset Class
Fund managers and investors will typically diversify their portfolios by investing in a variety of different asset classes and assigning a percentage of the portfolio to each. Different asset classes can include stocks, bonds, real estate, ETFs, commodities, and cash and short-term cash equivalents.
Opting to invest in both domestic and foreign markets is a good diversification strategy. Firstly, foreign markets tend to be less correlated to domestic ones. For example, if changes in the US economy cause US stocks to take a downturn, stocks in China may not be affected in the same way.
In the same way that different markets perform differently so do different industries. For example, if an investor built a portfolio that focussed solely on the technology industry and a change in regulation or supply chain issue occurred, their entire portfolio could be impacted.
If however, tech investments only made up 10% of their portfolio the other 90% of investments, depending on the industry, may not be as affected and could cushion the losses from the tech investments.
Advantages of Diversification
The advantages of diversification include:
Limits Portfolio Risk
Building a diversified portfolio can help investors significantly reduce their exposure to risk and avoid losing a large percentage of their investment.
Protects Against Volatility
Economic, political or global events can lead to market volatility, but having a diversified portfolio can help investors protect against this by limiting their risk exposure and losses.
Higher Return in The Long-Term
While in the short-term investors may see small losses, in the long-term, on average, diversified portfolios yield higher long-term returns.
Disadvantages of Diversification
The disadvantages of diversification include:
Limits Short-Term Gains
If a particular stock or security in your portfolio achieves short-term gains, your share of these gains will be reduced compared. For example, that security may only make up 10% of your portfolio but if you had invested 50% your returns would be higher.
Transaction Fees and Commissions
Trading and investing in a variety of securities and markets can incur more transaction fees and brokerage commissions. As long as the gains of diversification outweigh these costs it can still be a worthwhile strategy.
Adopting the diversification strategy can make managing your portfolio more time-consuming. With more to keep track of and more to consider it can take more time than if you focussed on a single market or asset class.