What is Diversification?
Investing Diversification Overview
Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. Diversification is most often done by investing in different asset classes such as stocks, bonds, real estate, or cryptocurrency. Diversification can also be achieved by buying investments in different countries, industries, sizes of companies, or term lengths for income-generating investments.
The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.
Diversification Strategies
Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.
As investors consider ways to diversify their holdings, there are dozens of strategies to implement. Many of the strategies below can be combined to enhance the level of diversification within a single portfolio.
Asset Classes
Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Each asset class has a different, unique set of risks and opportunities. Classes can include:
Stocks—shares or equity in a publicly traded company
Bonds—government and corporate fixed-income debt instruments
Real estate—land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
Exchange-traded funds (ETFs)—a marketable basket of securities that follow an index, commodity, or sector
Commodities—basic goods necessary for the production of other products or services
Cash and short-term cash-equivalents (CCE)—Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments
Industries/Sectors
There's tremendous differences in the way different industries or sectors operate. As investors diversify across different industries, they become less likely to be impacted by sector-specific risk. Below are a few industry examples:
Technology
Financial
Automotive
Retail
Housing
Healthcare
Corporate Lifecycle Stages
Public equities tend to be broken into two categories: growth stocks or value stocks. Growth stocks are stocks in companies that are expected to experience profit or revenue growth greater than the industry average. Value stocks are stocks in companies that appear to be trading at a discount based on the current fundamentals of a company.
Growth stocks tend to be more risky as the expected growth of a company may not materialize. However, growth companies may tap into seemingly limitless potential and exceed expectations, generating even greater returns than previously expected.
On the other hand, value stocks tend to be more established, stable companies. While these companies may have already experienced most of their potential, they usually carry less risk. By diversifying into both, an investor would capitalize in the future potential of some companies while also recognizing the existing benefits of others.
Market Capitalizations (Large vs. Small)
Investors may want to consider investing across different securities based on the underlying market capitalization of the asset or company (large cap companies versus small cap companies). Broadly speaking, lower cap stocks have more room to grow, though higher cap stocks tend to be safer investments.
Risk Profiles
Across almost every asset class, investors can choose the underlying risk profile of the security. For example, consider fixed-income securities. An investor can choose to buy bonds from the top-rated governments in the world or to buy bonds from private companies that are raising emergency funds. There are considerable differences between several 10-year bonds based on the issuer, their credit rating, their future operational outlook, and their existing level of debt.
The same can be said for other types of investments. Real estate development projects with more risk may carry greater upside than established, operating properties. Meanwhile, cryptocurrencies with longer histories and greater adoption such as Bitcoin carry less risk compared to smaller market cap coins or tokens.
Maturity Lengths
Specific to fixed-income securities such as bonds, different term lengths impact different risk profiles. In general, the longer the maturity, the higher the risk of fluctuations in the bond's prices due to changes in interest rates. Short-term bonds tend to offer lower interest rates; however, they also tend to be less impacted by uncertainty in future yield curves. Investors more comfortable with risk may consider adding longer term bonds that tend to pay higher degrees of interest.
Locations (Foreign vs. Domestic)
Investors can reap further diversification benefits by investing in foreign securities. For example, economic forces depressing the U.S. economy may not affect Japan's economy in the same way. Therefore, holding Japanese stocks gives an investor a small cushion of protection against losses during an American economic downturn.
Tangibility
Financial instruments such as stocks and bonds are intangible investments; they can not be physically touched or felt. On the other hand, tangible investments such as land, real estate, farmland, precious metals, or commodities can be touched and have real world applications. These real assets have different investment profiles as they can consumed, rented, developed on, or treated differently than intangible or digital assets.
There are also unique risks specific to tangible assets. Real property can be vandalized, physically stolen, damaged by natural conditions, or become obsolete. Real assets may also require storage, insurance, or security costs to carry. Though the revenue stream is different than financial instruments, the input costs to protect tangible assets is also different.
Diversification Across Platforms
Another aspect of diversification relates to how assets are held. Though this not an implication of the investment's risk, it is an additional risk worth considering as it may be diversifiable. For example, consider an individual with $400,000 of U.S. currency. In all three of the situations below, the investor has the same asset allocation. However, their risk profile is different:
The individual may deposit $200,000 at one bank and $200,000 at a second bank. Both deposits are under the FDIC insurance limit per bank and are fully insured.
The individual may deposit $400,000 at a single bank. Only a portion of the deposit is covered by insurance. In addition, should that single bank experience a bank run, the individual may not have immediate access to cash.
The individual may physically store $400,000 of cash in their home. Though immediately accessible, the individual will not yield any interest or growth on their cash. In addition, the individual may lose capital in the event of theft, fire, or misplacing cash.
Pros and Cons of Diversification
The primary purpose of diversification is to mitigate risk. By spreading your investment across different asset classes, industries, or maturities, you are less likely to experience market shocks that impact every single one of your investments the same.
However, there are drawbacks to diversification, too. The more holdings a portfolio has, the more time-consuming it can be to manage—and the more expensive, since buying and selling many different holdings incurs more transaction fees and brokerage commissions. More fundamentally, diversification's spreading-out strategy works both ways, lessening both the risk and the reward.
Pros
Reduces portfolio risk
Hedges against market volatility
Offers potentially higher returns long-term
May be more enjoyable for investors to research new investments
Cons
Limits gains short-term
Time-consuming to manage
Incurs more transaction fees, commissions
May be overwhelming for newer, unexperienced investors
Conclusion
Diversification is a very important concept in financial planning and investment management. It is the idea that by investing in different things, the overall risk of your portfolio is lower. Instead of putting all of your money into a single asset, spreading your wealth across different assets puts you at less risk of losing capital. With the ease of transacting and investing online, it is now incredibly easy to diversify your portfolio through different asset classes and other strategies.
Happy Trading, Verdia
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