Diversification is a growth strategy that takes advantage of market opportunities aiming to reduce the portfolio risk by allocating investment interest over different classes of assets. Through the acquisition and efficient management of two or more different assets, diversification leverages investment risk by offsetting losses from one asset with the gains of another asset in the same portfolio. As a result, as the number of the multiple assets in the portfolio increases, the total portfolio risk decreases.
Diversification is essential for all investors. Constructing a diversified portfolio is important to the growth of the investment. Savvy investors have different investment classes in their portfolio such as stocks, mutual funds, bonds, cash, or commodities and they protect their portfolio from losing value if one asset category declines sharply. However, although asset allocation may seem a straightforward form of diversification, still it requires a good knowledge of investment fundamentals.
The first rule of diversification is to know the basics of each investment class.
Stocks are financial assets of equity investing that offer ownership or a share of the company to the investor. When a firm is viable and profitable, its market capitalization increases and so does the value of its stocks. Stocks are generally considered as riskier than all other financial assets because they are susceptible to more frequent and sharper fluctuations and market volatility. Yet, as investors have different investment profiles that differ in the level of risk that are willing to undertake, the investment goals are directly proportional to the fluctuations of the stocks. Risk-takers investors invest in aggressive stocks, which generate instant income. Risk-averse investors prefer stocks that generate average returns on a long-term horizon.
Mutual funds are combined holdings of different classes of assets that belong to one portfolio and have cost less if purchased collectively than if purchased individually. Mutual funds can be thought as a pool of money from different individual investors who invest their money in shares, holding a portion of the fund. Mutual funds are considered less risky than all other assets because the fund diversifies the portfolio.
Buying a bond is similar to lending money to a government or corporation to raise funds. In return, investors get a fixed interest rate. Bonds are less risky than stocks, but they bear the inflation risk. The longer the investment horizon the riskier the investment because the possibility that the market interest rates increase more than the bond fixed interest rate due to increased inflation rates is higher, causing the portfolio value to decline. Therefore, it is more profitable to invest in short-term bonds to anticipate the increase of interest rates.
When investing in cash, it is important to consider the time value of money. Investing in a certain amount of money today doesn’t mean that this amount will have the same value after a certain period of time, even if its value is higher. This happens because cash is subject to inflation fluctuations. For instance, $100 today, invested at an interest rate of 5% will have a value of $105 in one year. Yet, the purchasing power of $105 in one year will not be the same as today because the inflation rate in one year may be higher. Therefore, to be profitable, the expected return on a cash investment should always exceed the inflation rates.
Because investment classes differ in their risk leverage, portfolios behave differently to market fluctuations according to what they include. For instance, when stock prices decline, bond prices rise because investors shift their money to bonds that are generally considered a safer investment than stocks. A portfolio consisting of stocks and bonds would perform differently than a portfolio consisting of stocks only at a time when stocks decline.
Another form of diversification can include industry allocation. By diversifying portfolio mix, not only with investment classes, but also with different industries, investors can leverage the investment risk.
Diversification can also include investments of different risk. Different investments with different expected rates of return are more likely to offset the losses of a portfolio. Besides, buying on average 10-12 diversified stocks is the optimum diversification level.
Conclusively, diversification is a good strategy, provided it is implemented properly, according to prevailing market realities. In times of financial uncertainty it makes more sense to diversify into investment vehicles that are less risky and safer.
Christina Pomoni
I work as a financial and investment advisor but my passion is writing, music and photography. Writing mostly about finance, business and music, being an amateur photographer and a professional dj, I am inspired from life. Being a strong advocate of simplicity in life, I love my family, my partner and all the people that have stood by me with or without knowing. And I hope that someday, human nature will cease to be greedy and demanding realizing that the more we have the more we want and the more we satisfy our needs the more needs we create. And this is so needless after all.
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