Diversification is a term familiar to most investors. In the most general sense, it can be summed up in one sentence: “Don’t put all your eggs in one basket.” Although this sentiment does capture the essence of the problem, it provides little information about diversification as an investment. Guidance on the actual impact of a part of the investor’s portfolio. In addition, it does not have an in-depth understanding of how diversified investment portfolios are actually created. In this article, we will provide an overview of diversity and give you insight into how to use it to your advantage.
- The idea of diversification is to create a portfolio of multiple investments to reduce risk.
- Most investors develop asset allocation strategies for their investment portfolios mainly based on the use of stocks and bonds.
- Although stocks and bonds are traditional tools for portfolio construction, many alternative investments (such as real estate investment trusts, hedge funds, art and precious metals) provide opportunities for further diversification.
What is diversity?
The idea of diversification is to create a portfolio of multiple investments to reduce risk. For example, consider an investment consisting of shares issued by only one company. If the company’s stock suffers a severe decline, your portfolio will bear the brunt. By splitting the investment between the stocks of two different companies, you can reduce the potential risk of your investment portfolio.
Reduce risk by including bonds and cash
Another way to reduce portfolio risk is to add bonds and cash. Since cash is usually used as a short-term reserve, most investors use stocks and bonds to develop asset allocation strategies for their investment portfolios. Keeping some investment assets as cash or short-term money market securities is never a bad idea. Cash can be used in emergencies, and short-term money market securities can be liquidated as soon as investment opportunities arise-or if your usual cash needs surge and you need to sell your investment to pay. In addition, please remember that asset allocation and diversification are closely related concepts; a diversified investment portfolio is created through the asset allocation process. When creating a portfolio of stocks and bonds, aggressive investors may prefer an 80% stock and 20% bond portfolio, while conservative investors may prefer a 20% stock rather than an 80% bond portfolio.
Balance of stocks and bonds
Whether you are aggressive or conservative, using asset allocation to reduce risk by choosing a balance of stocks and bonds for your portfolio is a reliable way to create a diversified portfolio. Some mutual funds aim to have a portfolio of securities including stocks and bonds to create a ready-made “balanced” investment portfolio. The specific balance of stocks and bonds in a given portfolio is designed to create a specific risk-reward ratio that provides you with an opportunity to obtain a certain return on investment in exchange for your willingness to accept certain risks. Generally speaking, the greater the risk you are willing to take, the greater the potential return on your investment.
What are my options?
If you are a person with limited financial resources, or you just like simple investment solutions, you can choose a single balanced mutual fund and invest all your assets in the fund. For most investors, this strategy is too simplistic. Although a given investment portfolio may be suitable for a child’s college education fund, this combination may not be suitable for long-term goals, such as retirement or estate planning.
Similarly, investors with large amounts of capital often need strategies designed to meet more complex needs, such as minimizing capital gains taxes or generating a reliable income stream. In addition, although investing in a single mutual fund can diversify between basic asset classes such as stocks, bonds, and cash (funds usually hold small amounts of cash and collect fees from them), the opportunities for diversification go far beyond these basic classes.
Equity investment options
For stocks, investors can choose a specific style, such as focusing on large, mid or small caps. In each of these areas, stocks are additionally classified as growth or value. Other selection criteria include choosing between domestic and foreign stocks. Foreign stocks also provide subcategories including developed markets and emerging markets. Foreign and domestic stocks can also be used in specific industries, such as biotechnology and healthcare.
In addition to diversified equity investment options, bonds also provide diversified opportunities. Investors can choose long-term or short-term issuance. They can also choose high-yield bonds or municipal bonds. Once again, risk tolerance and personal investment requirements will largely determine investment choices.
Further diversification options
Although stocks and bonds are traditional tools for portfolio construction, many alternative investments provide opportunities for further diversification. Real estate investment trusts, hedge funds, artworks, precious metals and other investments provide opportunities to invest in tools that may not necessarily develop in tandem with traditional financial markets. However, these investments provide another way to diversify the portfolio.
Disadvantages of diversification
With so many investments to choose from, diversification seems easy to achieve, but this is only partially true. Investors still need to make wise choices. In addition, your investment portfolio may be overly diversified, which will have a negative impact on your returns. Many financial experts agree that 20 stocks are the best number for a diversified stock portfolio. With this in mind, buying 50 stocks or 4 large-cap mutual funds may do more harm than good.
Investing too much in your portfolio will not make any investment too much. Over-diversified portfolios (sometimes called “diversification”) usually start to behave like index funds. In the case of holding a small number of large-cap mutual funds, multiple funds bring the additional risks of overlapping holdings and various fees-such as low balance fees and different expense ratios-which could have been avoided by more cautious funds choose.
No matter what means or method you use, please remember that there is no single diversified model that can meet the needs of every investor. Your personal time frame, risk tolerance, investment goals, financial means and investment experience level all play a huge role in determining your investment portfolio. If you are overwhelmed by choices, or just prefer commissioning, there are many financial services professionals who can help you.