Diversification: Important Concept in Investment Management
Diversification is the practice of spreading your money among several different investments to reduce risk in case of any single investment failing. Diversification is one of the most important concepts in investment management and financial planning. Every investor needs to understand the importance of diversification and how to apply it to their portfolios.
How Investment Diversification Works
A portfolio containing various types of assets, such as stocks from a wide range of industries and bonds from different financial institutions, is less likely to lose value drastically. A portfolio with a wide mix of investments may generate a higher rate of return than a portfolio consisting of only one type of asset or a portfolio containing assets that belong to only one industry.
Diversification is a strategy that is not limited to stock market assets. Besides investing in stocks, bonds, index funds, and ETFs, you can diversify your portfolio by investing in real estate, commodities, cryptocurrency, or other asset classes that may be less sensitive to traditional markets. You can diversify your investments by investing in domestic and foreign markets and selecting investments with different risk profiles. Your portfolio can be as diverse as your goals, financial situation, and risk tolerance requires.
The asset mix in your portfolio depends on your risk tolerance, time horizon, and income needs. For example, a more risk-tolerant person with a longer time horizon may invest in a portfolio of stocks for long-term growth prospects. A younger person with decades of investing career ahead may choose to invest in equities because there is enough time for the market to recover from drastic losses and generate higher returns.
On the other hand, a risk-averse person with a shorter time horizon may invest in a portfolio of bonds to reduce the impact of market volatility and preserve the original value of the investments. Older people and those who save for short-term goals may be more concerned about the potential for losses in a volatile market and may want to protect their savings by having a more diverse portfolio with mostly low-risk investments.
What is the Best Way to Diversify a Portfolio?
You should align the asset mix in your portfolio with your financial objectives. Your financial goals, time horizons, and risk tolerance will influence the appropriate investment mix in your portfolio. If you are unsure how much diversification is right for you, learn about developing your investment strategy or work with a financial advisor to determine the appropriate asset allocation for your portfolio.
Related: Developing Your Investment Strategy
Pros and Cons of Diversification
Diversification can help investors find the right balance between potential returns and risk. It can help more risk-tolerant investors to avoid catastrophic losses and help risk-averse investors stay invested in the market by reducing the volatility of their portfolios.
Diversification does not necessarily have downsides, but it does have some nuances to consider. For example, the cost of managing a large asset mix may be higher - more assets in the portfolio mean more transaction fees and brokerage commissions. Portfolio management and performance assessment may become more time-consuming as an investment portfolio grows. However, it is not always the case. Exchange-traded funds (ETF) and mutual funds can provide better diversification at a lower cost and may be easier to manage than a portfolio of individual equities.
Risk and reward are generally inversely correlated. For example, the amount of risk is typically low when the probability of success is high, and vice versa. In a well-diversified portfolio, it's less likely that a single asset will be responsible for a large portion of your losses, but as a result, the returns may be lower as well.
Protecting your portfolio from risk may result in a lower return, but the cost of a failed investment can be far more damaging to your financial health because the reward is never guaranteed.