What Is Diversification?
Diversification is the process of investing in a variety of securities that don’t correlate with each other much in order to spread out risk. Diversification is most commonly referred to as “not putting all your goods in one basket.”
Why Diversify?
The biggest benefit to portfolio diversification is the spread of risk. For every investor, it is very common to see some profits and many losses. Therefore, by investing in many securities with differing characteristics, not all securities will react to market conditions the same way. Even if a few don’t do well, you will still have other securities to hopefully cancel out the losses. Ultimately, investors see greater gains in the long-run.
For beginner investors, diversification is a great way to have their money in various different sectors. One can easily learn how different industries react to market booms/busts and global events, and how different industries tend to perform in relation with each other. Diversification will help investors build a clearer picture of what type of investor they want to be (check out the Bullish Advisor’s blog on “Types of Investors” to learn more) to determine how they want to invest.
Types of Diversification
There are 4 main types of diversification:
- Asset Class Diversification
Spread investments across different asset classes of securities. The main assets are stocks, bonds, real estate, commodities, and cash equivalents. Therefore, asset class diversification would mean investing in a few common stocks, a few government bonds, and having an investment property.
- Geographic Diversification
Invest in companies on different scales such as international and domestic companies. That way domestic events might negatively influence the domestic companies, but the international companies aren’t as affected.
- Time Diversification
Time diversification, also known as dollar cost averaging, is a method of investing where one invests a fixed amount of money at regular intervals throughout the year. Because the market price for the security will typically vary during the different intervals, the value the investor derives from that investment will be an average of the various market prices. This average will protect against the intervals that had lower returns.
- Risk-level Diversification
Invest in various degrees of risk. For example low-risk securities often include government bonds, CDs, T-Bills, and mutual funds. Moderate risk is associated with corporate bonds, REITs (real estate investment trusts), and preferred stocks (learn more about preferred stocks in our “Types of Stocks” blog). Finally, high risk securities include common stocks, commodities, futures, and crypto.
Common Mistakes to Avoid
- Overdiversification
Even in a diversified portfolio, there should be a balance of asset classes. The portfolio should estimate positive returns since some of the risk is being balanced with securities that you know will perform well regardless of market performance. Don’t diversify your portfolio to the point where there is no risk (so no returns).
- Pay Attention to Correlation
Even different asset classes typically trend or respond to market fluctuations in the same manner. For example, high-yield bonds are known to perform similarly to stocks. This is because high yield bonds are issued by companies with relatively lower credit ratings. So, investors typically invest in stocks and high yield bonds when they are willing to take on more risk. Therefore, if your portfolio only had securities from these 2 asset classes, your overall portfolio may perform uniformly.
Conclusion
Diversification is a crucial strategy for managing risk and optimizing returns in a portfolio. By spreading investments across various asset classes, geographic regions, time periods, and risk levels, investors can mitigate the impact of poor performance in any single investment. That is all for today, readers! Stay tuned for more in-depth analyses and tips in our upcoming blogs, where we’ll delve deeper into stock markets, financial ratios, and other essential investment topics. The Bullish Advisor thanks you for stopping by!