Let us define diversification.
Traders and investors have different experiences that help them develop styles and strategies that work for them. There is a strategy called “diversification,” where people throw in various types of investments in their portfolios to avoid exposing themselves to risks. Hence, if the investor has different assets or investment vehicles in his portfolio, he has lesser risk exposure from a single type of asset if it declines massively. Aside from this reason, investors use this strategy because they want to yield long-term results.
It’s like a balance.
The reason behind diversifying the portfolios is balance. If investments of the same kind perform terribly, the others should balance that with the others that perform well since they are not similar. In a way, the investor does not lose a hefty amount of money because of this strategy where the securities in his portfolio are not correlated. And when we say that they are not correlated, we mean that they are going in opposite ways. They respond differently and under different influences.
Is it a proven strategy?
Strategies are called strategies for a reason. They do not guarantee 100% success, but they can help traders if done right. People have tried and studied this strategy. Others even devised mathematical models saying that there will be risk reduction if an investor diversifies his portfolio well.
For more specific information, a well-diversified portfolio with 25 to 30 stocks is said to be the one that yields the best cost-effective risk reduction level among any other quantity. Hence, more securities mean more benefits, but the rate is lower.
Investors or fund managers diversify their portfolios across different asset classes and dictate how much percentage it will be in the portfolio. These are the various asset classes:
- Real estate
- Exchange-traded funds (ETFs)
- Cash and short-term cash-equivalents (CCE)
They will further diversify their investments within the chosen asset classes.
Taking diversification to the next level
Some investors and fund managers step up their diversification by throwing in some securities from a foreign country in their portfolios. Why? Foreign securities are less correlated with the ones in their country. For example, the things that affect the economy of Country A may not affect Country B’s economy. Taking foreign securities gives further assurance and protection from losses.
The good and the bad
We have mentioned several of the benefits that an investor or a fund manager can get from portfolio diversification. The first of the list is risk reduction. Aside from that, it can also offer long-term high returns and can hedge market volatility. However, it also has downsides. Diversifying a portfolio is not only time-consuming and more complex to manage. It also limits an investor’s short-term gains. Aside from that, it also means more transaction fees or commissions than focusing on similar asset classes and types. So, if you are interested in this strategy, you should study it well to execute it well. Weigh the pros and cons if it’s the right strategy for you.