What is diversification? A portfolio strategy that uses a variety of investments to limit risk
Diversificationis an investment strategy that consists of holding a combination of investments within and between asset classes.
- The main objective of diversification is to reduce a
walletexposure to risk and volatility.
- Because it aims to smooth out fluctuations in investments, diversification minimizes losses but also limits gains.
If you know the proverb “Don’t put all your eggs in one basket, ”you have a basic understanding of investing diversification.
Diversification consists of dividing your money into several investments and several kinds of investments. The idea is that your portfolio will be protected if a particular asset, or a group of assets, loses money.
For example, if you put all of your money in one stock, your entire investment could be wiped out if that company goes bankrupt. Or (less dire scenario) not growing much if that business or its industry is having a hard time. However, by investing in 20 stocks, you are spreading your risk. Even if five stocks go down, you can still make money overall if the other 15 go up.
Diversification cannot completely eliminate risk – when it comes to investing, almost nothing is 100% sure. But it can significantly reduce your exposure to risk. Different investments are subject to different influences and different degrees of volatility (price changes). In a well-diversified portfolio, they balance each other out, keeping your finances and their growth on a level playing field.
What is diversification?
When financial experts talk about diversification, they can refer to a variety of strategies. You can diversify by keeping in mind:
- Level of risk (low to high)
- Investment needs (income, appreciation, aggressive growth)
- Liquidity (from pure cash to less tradable assets)
- Time horizon (from immediate return to long term)
Of course, these diversification goals may overlap: Aggressive growth stocks are the ones you would like to hold for the long term; highly liquid investments tend to be low risk. Regardless of the strategy, they all have the same goal: to protect a portfolio from the shocks and bruises of volatile movements, especially downward ones.
And they’re executed basically the same way: by the types of assets you invest in.
Diversification between asset classes
One of the essential characteristics of diversification is called asset allocation, which simply means investing in different types of financial instruments i.e. assets. When it comes to investing, assets fall into two broad categories:
- Traditional (what we generally think of as investments – pure money vehicles, like stocks, bonds, and cash)
- Alternative (often more tangible things, like goods, or exotic instruments, like derivatives)
Within these two broad areas are several sub-categories or asset classes. Here are the main ones for individual investors:
To be considered or well diversified, a portfolio – or at least all of your financial holdings – must contain assets from at least three of these classes. For example, real estate could be represented by the house you own.
Diversification within asset classes
In addition to diversifying between asset classes, it is important to consider diversification in asset classes. This is especially true with something like stocks, which is arguably the largest and most diverse of asset classes.
You can analyze stocks in different ways. One of the most common, when it comes to diversifying, is to look at them by sector, that is, the industry to which they belong.
Investing only in shares of Facebook, Google, Apple and Microsoft, for example, would be far from ideal since all of these companies are part of the tech sector, and therefore are affected by the same factors, have the same strengths and weaknesses. . Investing in stocks from other sectors such as energy, industrials or financials might help you build a more complete portfolio, as they would have different characteristics and might react differently under different economic conditions.
The importance of a diversified portfolio
Diversification provides security by cushioning shocks that can affect particular assets. But what’s particularly interesting is that it can help investors limit their risk without drastically lowering long-term returns. In a study of average portfolio returns and volatility from 1926 to 2015, Fidelity Investments compared the performance of diversified portfolios in several different ways, including “aggressive” (mostly invested in equities, for strong growth) and “balanced” (split more evenly between bonds for income and stocks for appreciation).
Fidelity found that the spread between best and worst 12-month returns was 79.64 percentage points higher for “aggressive” portfolios than for “balanced” portfolios. Yet despite significantly higher volatility, aggressive portfolios only outperformed average annual returns by 1.69%. So, for a compromise of 1.69% lower yields, you could have enjoyed a smoother ride with much less sharp dips along the way.
It is important to stress, however, that even the most thoughtful diversification strategies cannot completely eliminate losses, especially in the short term. In the Fidelity study, even the most conservative portfolios suffered a 17.67% loss in their worst 12-month periods.
Disadvantages of diversification
Diversification is, in many ways, a given. But of course there are always downsides. Here are two to remember:
- Diversification, by design, limits your returns to “average”. You bet on many companies / types of investments with the aim of having more winners than losers. But the clunkers will bring down the stars. So while diversified portfolios are expected to experience fewer massive declines than aggressive (less diversified) portfolios, they are also less likely to experience extreme highs.
- Diversification can be expensive and time consuming. Finding dozens or hundreds of stocks and bonds can take a lot of effort. Additionally, purchasing a variety of different investments can be costly, especially for the individual investor.
The second reason is why mutual funds, index funds and exchange traded funds (ETFs) have become the gold standard for individual investors. Buying into these baskets of securities helps you achieve instant diversification, not only within asset classes, but between them.
And investors can even choose to diversify their holdings into funds with different levels of risk.
For example, below are three popular types of mutual funds:
- Growth funds: Invest in companies that are expected to earn faster than average earnings and tend to be the most volatile.
- Income Fund: Invest primarily in dividend-paying stocks and focus on long-term income rather than short-term capital appreciation.
- Balanced funds: Provide the greatest diversification by investing in stocks, bonds and cash equivalents, both for capital appreciation and income.
The financial report
Diversification is a simple concept, although there are many ways to achieve it. And it is something fluid. Diversifying your portfolio is not a ‘set it and forget it’ activity. As your goals change or as you get older, chances are you will need to change your asset allocation.
Here are three more tips for diversifying your portfolio:
- Keep an eye on your investment costs: Fund costs, trading commissions and advisory fees can reduce your overall returns. Try to avoid expensive fund transaction fees and charges (commissions) and be sure to compare fund expense ratios.
- Consider a target date or asset allocation funds: Mutual funds or asset allocation ETFs invest in a predefined combination of stocks and bonds (i.e. 80/20, 70/30 or 60/40) at all times and automatically rebalance. And target date funds go one step further by constantly adjusting to a more conservative mix as you approach retirement.
- Reassess regularly: As some assets in your portfolio are outperforming (or underperforming), your portfolio weightings may deviate from your target allocation. By rebalancing your portfolio once or twice a year, you ensure that your asset allocation is always in line with your risk tolerance.
Keep in mind that “the main goal of diversification is not to maximize returns. Its main objective is to limit the impact of volatility on a portfolio, ”as the Fidelity study notes. In other words, diversification is a defensive move. But it’s the one every investor should do, at least to some extent.