Portfolio diversification is a strategy that involves allocating funds across a variety of different securities and assets to reduce risk and improve overall potential returns. It is recommended by financial experts because it helps to spread out the risk and prevents your portfolio from being too dependent on one particular asset.
What is diversification?
Diversification is a key strategy for managing portfolios and risks. Effective risk management involves spreading out allocations to minimise vulnerability to market changes.
The concept of diversification is simple - instead of putting all your eggs in one basket, you spread them out across multiple baskets. This way, if one allocation underperforms or experiences a loss, the impact on your overall portfolio is minimised because the other allocations can potentially offset those losses.
A diversified portfolio can consist of various types of assets, including stocks, bonds, funds, real estate, CDs, and even savings accounts. As each asset class behaves differently in different economic conditions, it offers varying levels of potential gain and loss.
While we won't cover this topic here, it's worth noting that when referred to in a business sense, diversification involves expanding product offerings or entering new markets to reduce reliance on a single revenue source and mitigate risks.
Exploring the concept of diversification in portfolio management
Diversification involves spreading allocations across various asset classes to reduce risk exposure. For instance, allocating funds to stocks, bonds, and cash equivalents simultaneously forms a diversified portfolio, or allocating funds to stocks across several countries and industries.
Diversification minimises the impact of poor performance in one asset class. In contrast to relying solely on a single asset type, diversified portfolios provide a safety net against market volatility, enhancing long-term stability.
Different types of asset options
Below we explore a number of asset options that can be utilised in a diversified portfolio:
Stocks
- Stocks tend to have the highest long-term potential returns but can also experience significant volatility in the short term.
Funds
- Funds can be diversified if they hold many different assets, but some funds may focus on a specific industry or sector.
Bonds
- Bonds offer more stable potential returns with fixed payouts but are influenced by changes in interest rates.
CDs and savings accounts
- CDs and savings accounts provide stability and steady growth based on interest rates.
Real estate
- Real estate can provide slow appreciation over time and potential income, but it also involves maintenance costs and high commissions.
By owning a mix of these assets, you can benefit from the different performance characteristics they offer. When some assets are performing well, others may not be doing as well, and vice versa. This lack of correlation between assets is what makes diversification effective in reducing risk.
The benefits of diversification
Diversification not only helps to reduce the risk of your portfolio, but it can also improve your potential returns. By spreading your allocations across different types of assets, you are more likely to have a smoother overall potential return. While one asset may be experiencing a downturn, another asset may be performing well, balancing out the overall performance of your portfolio.
It's important to note that while diversification can reduce risk, it cannot eliminate all risk. Diversification helps to reduce asset-specific risk, such as the risk associated with having too much allocation in one stock or one type of asset. However, it cannot protect you from market-specific risk, which is the risk associated with owning a particular type of asset in general.
How to build a diversified strategy
To develop a diversification strategy, you can start by creating a portfolio that includes a mix of different assets. Be sure to allocate based on your personal risk tolerance, time horizon, and financial objectives. Below are several options to consider when building a diversified portfolio.
Examples of building a diversified portfolio
Please note that this is not financial advice but merely examples of how one might diversify their portfolio.
You might explore the option of allocating funds to a widely diversified index fund, such as the S&P 500 index, which holds interests in numerous companies. Combining bonds and CDs could contribute to portfolio stability and assured potential returns. Holding cash in a savings account can offer stability and act as a financial safety net.
If you're inclined to expand beyond the fundamental approach, further diversifying your stock and bond allocations is an option. For stocks, you could contemplate allocating funds to a fund targeting emerging markets or international corporations, as these often diverge from broader index funds. Regarding bonds, varying maturity lengths in bond funds can grant access to short-term and long-term bonds.
Some financial professionals even suggest the consideration of including commodities like gold or silver to extend diversification beyond conventional assets.
Building a diversified portfolio may seem complex, but it doesn't have to be. You can utilise low-cost mutual funds or exchange-traded funds (ETFs) that offer diversification across different asset classes. Many major brokerages now offer these funds with zero commissions, making it a more accessible and cost-effective offering for those allocating funds.
If you prefer a more hands-off approach, you could contemplate allocating funds to a target-date fund or utilising a robo-advisor. Target-date funds recalibrate asset allocation according to your planned time horizon, progressively adjusting to lower-risk assets. Robo-advisors use algorithms to formulate and sustain a diversified portfolio grounded in your objectives and risk tolerance.
Risk management
Be sure to regularly review and rebalance your portfolio to ensure it aligns with your objectives. Assessing and adjusting the asset allocation helps maintain desired levels of risk and potential returns.
In conclusion
Diversification is an essential strategy for those looking to reduce risk and potentially improve returns. By spreading allocations across different assets, you can mitigate the impact of any single asset's performance on your overall portfolio.
Whether you choose to build a diversified portfolio yourself or seek assistance from a fund or robo-advisor, diversification can help you navigate varying economic conditions and work towards your financial objectives.
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