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Understanding of Diversification. How does it work?

Understanding of Diversification. How Does It Work?

Diversification is a risk management strategy of allocating portfolio resources or capital to a mix of different investments. Rather than putting money in a single firm, industry, sector, or asset class, investors diversify their investments across a range of different firms.

A diversified portfolio contains a wide variety of asset types and investments, which reduces the portfolio’s volatility. It offsets losses in one asset class with gains in another asset class.

 

Why Do We Need It?

 

You need diversification to minimize investments risk. As we know, the future is highly uncertain, and markets are always fluctuating. If we had perfect knowledge of the future, of course, we should pick one investment that would perform perfectly. However, the future is unknown, so diversification is a great way to manage risk. While diversifying our investments among different corporations and assets, we know that our investments are not exposed to the same risk.

Some people consider that diversification aims to maximize return. However, that isn’t correct. Investors who direct capital in a limited number of investments may outperform a diversified investor. Meanwhile, a diversified portfolio generally performs better than the majority of more-focused ones. Remarkably, this fact underscores the challenges of trying to pick just a few winning investments.

According to several studies and mathematical models, maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Notably, investing in more securities gives further diversification benefits, however, at a drastically lower rate.

Investments always perform differently in similar markets. For instance, when stock prices increase, bond yields are generally dipping, meaning that stocks and bonds are negatively correlated. We have seen moments when stock prices and yields move in the same direction, both increasing or both falling. However, as we know, stocks typically have much greater volatility, meaning they gain or lose much more than bonds.

The goal of diversification is to acquire assets that don’t move in lockstep with one another.

Here is an illustration for better understanding. Imagine James and Mary both make $200,000 a year in their business. James’ money comes from three different clients, while Mary’s money comes from one client. If the client Mary works for goes belly up, her income would be 0.

 

Different Types of Risk

 

Investors face two main types of risk when they invest. The first type of risk is systematic or market risk. This type of risk is associated with every firm/business. It is caused by inflation rates, exchange rates, political instability, war, and interest rates. The systematic risk is not specific to any business or industry. It cannot be eliminated or reduced by diversification. It is a type of risk that all investors must accept.

Meanwhile, the second type of risk is diversifiable or unsystematic. Unlike the abovementioned risk, this type of risk is specific to a firm, industry, market, economy, or country. Additionally, the most common sources of unsystematic risk are business risk and financial risk. It is diversifiable so that investors can reduce their exposure through diversification. Therefore, the aim is to invest in different assets to not all be affected the same way by market events.

 

Portfolio Diversification

 

As we have already mentioned, the diversification strategy required balancing different investments that have only a slightly positive correlation with each other or are negatively correlated. Low correlation generally means that the price of the investments is now likely to move in the same direction.

An investor should consider diversifying a portfolio based on several specifications. Let’s see some of them:

Types of investments: include different assets classes, including cash, stocks, bonds, ETFs, options, etc.

Risk levels: Investments with different levels of risk allow the smoothing of gains and losses.

Industries: Invest in firms from separate industries. The stocks of firms operating in different industries are usually less correlated with each other.

Foreign markets: A trader should not invest only in domestic markets. Remarkably, there is a high probability that the financial products traded in foreign markets show less correlation with products traded in domestic markets.

Furthermore, index and mutual funds, as well as ETFs, give the possibility individual investors to create diversified investments with a simple and inexpensive instrument.

 

The Primary Components of A Diversified Portfolio

 

Domestic Stocks

Stocks are the most aggressive portion of the portfolio and provide higher growth over the long term. However, it carries a greater risk, particularly in the short term. Stocks are usually more volatile than other types of assets.

 

Bonds

Most bonds offer regular interest income and are generally less volatile than stocks. Remarkably, they can act as a cushion against the unforeseeable ups and downs of the stock market. Individuals who are more focused on safety than growth often choose U.S. Treasury or other high-quality bonds. Therefore, they offer less than stock over the long term. However, some fixed-income investments can offer much higher yields.

 

Short-Term Investments

These include money market funds and short-term certificates of deposit. Money market funds are traditional investments that carry stability and easy access to your money, ideal for those looking to preserve principal. Remarkably, money market funds usually provide lower returns than bond funds or individual bonds.

 

International Stocks

Stocks issued by non-U.S. firms often perform differently than others, providing exposure to opportunities not offered by U.S. securities. Suppose you’re looking for investments that offer both higher potential returns and higher risk. In that case, international stocks are exactly what you need.

 

Disadvantages of Diversification

 

We have already mentioned pluses of diversification. However, there are also drawbacks. The more holdings a portfolio has, it is more expensive and time-consume to manage them. Moreover, buying and selling many different holdings incurs more transaction fees and brokerage commissions. In a word, diversification’s strategy works both ways, reducing both the risk and the reward.

Let’s say Robert invested $200,000 equally among five stocks, and one stock doubles in value. His original $40,000 stake is now worth $80,000.

Robert has made a lot, sure, but not as much as if his entire $200,000 had been invested in that one company.

Diversification limits your gains — at least, in the short term. However, over the long term, diversified portfolios tend to post higher returns.

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