Diversification can be neatly summed up as “don’t put all your eggs in one basket”, although this statement provides little guidance on the practical implication of the role diversification plays in an investor’s portfolio and offers no insight into how a diversified portfolio is actually created. The idea is that if one investment loses money, the other investments will make up for those losses. Diversification can’t guarantee that your investments won’t suffer if the market drops. But it can improve the chances that you won’t lose money, or that if you do, it won’t be as much as if you weren’t diversified.
Most investors are familiar with the term diversification, still some investors find it difficult to manage their investments efficiently, since not all investors can afford a fund or portfolio manager to manage their investments. Portfolio diversification is a strategy that mixes a wide variety of investments/securities that are not perfectly correlated in terms of industry or sector, that is, they respond differently, often in opposing ways to market influences. A diversified portfolio contains a mix of distinct asset types and investment vehicles (bonds, stocks, real estate and mutual fund) in an attempt at limiting exposure to unsystematic risk. Unsystematic risk is the risk that is inherent in a specific company or industry like a decline in consumer spending will affect stocks in consumer goods sector. By investing in a range of companies and industries, unsystematic risk can be drastically reduced through diversification.
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 strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others.
Why Diversification Is Important in Investing
Diversification is spreading your risk across different types of investments, the goal being to increase your odds of investment success (higher return) and reducing possible exposure to risk. It’s like saying since no one can know for certain who is going to win this race, let’s bet on everyone.
For instance, if someone had a portfolio of only transportation stocks when the government declared movement restriction as a result of Covid 19, share prices of transportation stocks dropped. That means your portfolio would have experienced a noticeable drop in value. If, however, you counterbalanced the stocks in transportation with a couple of stocks in Telecommunication, only part of your portfolio would have been affected. In fact, there is a good chance the price of telecommunication stocks would climb as a result of the restriction of movement. Therefore, you would want to diversify across the board, not only different types of companies but also different types of industries. The more uncorrelated your stocks are, the better.
It is also important to diversify among different asset classes such as stocks, bond and actual real estate (e.g. buying land properties or buildings). Different assets like bonds and stocks will not react in the same way to adverse events. Generally, bond and equity markets move in opposite directions, so if your portfolio is diversified across both areas, unpleasant movements in one will be offset by positive results in another.
Diversify Across Asset Classes
A combination of asset classes will reduce your portfolio’s sensitivity to market swings. As an investor you need to determine how you want to diversify across asset classes and what percentage of the portfolio to allocate to each financial instrument. When creating a portfolio that contains stocks, a widely accepted rule of thumb is that it takes around 20 to 30 stocks of different industries or companies to adequately diversify your stock. Although, this does not help in most cases since not everyone has the resources, that’s why you might consider investing in mutual funds that have a mix of securities that includes both stocks and bonds to create ready-made “balanced” portfolios. Across asset class diversification also entails that you invest in commodity paper or real estate or Exchange-traded fund (ETF). You can diversify against inflation by allocating part of your portfolio to real estate.
Pros and Cons of Investment Diversification
Diversification reduces an investor’s overall level of volatility and potential risk. When investments in one area perform poorly, other investments in the portfolio can offset losses. That is particularly true when investors hold assets that are negatively correlated, for example, Eurobond made significant gains when stocks declined in march 2020 as result Covid 19 pandemic which also resulted in devaluation of the naira against the dollar. Investment diversification also allow investors to hedge against market volatility (unstable exchange rate) and offers higher returns in long term.
However, there are drawbacks, 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, diversifying an investment portfolio tends to limit potential gains and produce average results.
Regardless of your means or method, keep in mind that there is no single diversification model that will meet the needs of every investor. Your personal time horizon, risk tolerance, investment goals, financial means, and level of investment experience all play a huge role in dictating your investment mix. If you are too overwhelmed by the choices or simply prefer to delegate, there are plenty of financial services professionals available to assist you.