What is Diversification?
The process of distributing a portfolio’s resources or capital among a variety of investments is known as diversification. By compensating for losses in one asset class with gains in another, diversification aims to lessen the volatility of the portfolio. “Don’t put all your eggs in one basket” is a saying frequently used in connection with diversification.
Risk is reduced by having “eggs” in different baskets; if one basket breaks, not all eggs are lost.
Diversification and Unsystematic Risk
The main purpose of diversification is to reduce or eliminate unsystematic risk. Unsystematic risk, also known as firm-specific risk, is a risk that exclusively impacts one company or a small group of related companies. As a result, when a portfolio is well-diversified, assets with good performance offset the drawbacks of investments that perform badly.
Diversification, however, typically has no impact on the inherent or systemic risk that applies to all financial markets.
The two primary categories of risk can be conceptualized as one referring to the specific dangers of a sector or individual company, and the other referring to risk elements in the general economy. Systematic risks entail underlying economic issues that are essentially beyond the control of any one particular organization, whereas unsystematic risks can typically be managed or reduced.
Diversifying a portfolio involves including many investment vehicles with a range of qualities. The goal of diversification is to balance a variety of investments that only slightly, or even better, really, negatively, correlate with one another. Low correlation typically denotes the likelihood that the prices of the investments will not move in lockstep.
Regarding the ideal level of variety, there is no general agreement. As long as there are investments on the market that are not correlated with the other investments in the portfolio, an investor might theoretically keep diversifying his or her portfolio indefinitely.
Based on the following criteria, an investor should think about diversifying his or her portfolio:
- Types of investments: Include a variety of asset classes, including cash, equities, bonds, ETFs, options, and so on.
- Risk level: Gains and losses can be smoothed out by choosing investments with different levels of risk.
- Industries: Invest in firms from various industries. The association between the stocks of companies engaged in other industries is typically less pronounced.
- Foreign markets: An investor shouldn’t limit their investments to local markets. The likelihood of financial items traded on international markets being less connected with those traded on domestic ones is substantial.
These days, index and mutual funds, along with ETFs, provide individual investors a straightforward and affordable tool for building a diversified investment portfolio.
How diversification can help reduce the impact of market volatility
Diversification doesn’t focus on maximizing profits as its main objective. Its main objective is to lessen the effect that volatility has on a portfolio.
The following graphic displays fictitious portfolios with various asset allocations: 60% US stocks, 25% foreign stocks, and 15% bonds make up the most aggressive portfolio, which had an average yearly return of 9.45%. While its worst 12-month return would have seen a loss of roughly 61%, its best 12-month return was 136%. Most investors probably couldn’t handle that level of volatility.
But by simply altering the asset allocation, it was possible to narrow the range of those swings without significantly compromising long-term performance. A portfolio, for instance, with a 49% domestic stock allocation, a 21% international stock allocation, a 25% bond allocation, and a 5% short-term investment allocation would have produced average annual returns of about 9% during the same time period, albeit with a narrower range of extremes on the high and low end. In contrast to the other asset allocations, increasing a portfolio’s fixed income holdings may dramatically lessen market volatility while only marginally reducing one’s expectations for long-term gains. Many investors believe that this trade-off is worthwhile, especially as people age and become more risk-averse.