Diversification plays a crucial role in reducing risks or volatility being an effective means of risk or portfolio management. In this post, we will delve into the world of diversification and understand how important it is for running a successful business. So, let us start unraveling the concepts associated with diversification-
What Is Diversification?
Diversification is a method of managing a collection in which an investor holds different types of investments to reduce the unpredictability of his portfolio. The various investments have low correlations with each other.
A portfolio is made of different types of assets and investment options which limits exposure of risk to any single type of asset.
The underlying principle behind this strategy is that a portfolio of various kinds of assets will give higher returns in the long run. It is because the risk associated with any single asset is averaged over the total portfolio.
Why choose Diversification
The main aim of diversification is to maximize return and reduce risk.
And this is achieved by spreading risk to several asset classes instead of concentrating it on one type of asset. In case one industrial sector suffers, the whole portfolio won’t hurt.
Also, risks of cyclical or seasonal fluctuations can be mitigated.
Capital is allocated to a mix of distinct types of investments.
The loss in a kind of asset return is thus offset by the gain on a different type of investment vehicle.
The phrase ‘Do not put all your eggs in one basket’ is the fundamental principle behind diversification. In case one basket breaks, all the eggs are not lost since the risk is mitigated by having eggs in various baskets.
Another Approach of Diversification
That is it spreads out to other fields instead of specializing in its core business activity. Thus the risk of relying on one source of income is reduced.
Industry experts suggest for such sort of diversification advice that all your capital should never be exposed to one particular kind of risk.
Let us now go deeper into the world of diversification and understand its working-
Basics of diversification, and how does it work?
Through diversification, unsystematic risks are smoothed in a portfolio.
The positive performance of other assets neutralizes the negative returns on some of the other investments.
The investment vehicles in the portfolio respond differently to market influences. That is, they are not correlated and meet in opposing ways.
Suppose a company invests $ 1 million in two different types of stocks.
50 % is invested in the healthcare stock of company XYZ, and 50 % is invested in the oil and gas stock of company ABC.
If the stock of company ABC goes from $ 2 to $ 1 per share, you lose the total amount associated with the number of shares you bought by 50 %.
On the other hand, if the healthcare sector performs well and per-share value of company XYZ goes from $ 2 to $ 4, you gain twice the amount associated with the share you bought. The gain in other stock balances the loss incurred in the first place.
The securities do not need to move together. If you invest in five different companies in one sector, probably that what affects one company’s stock will also affect the other company’s shares to some degree.
But if you purchase different stocks in companies belonging to different sectors, then it is less likely that one affects your stocks in one industry will be changing the stock in other sectors.
It can also go one step further.
The user can also invest in different asset classes such as bonds, stocks, and real estate. Portfolios can also be geographically diversified. The user can invest in domestic markets as well as foreign markets.
What are the Diversification across Asset Classes
For a portfolio to be diversified, it is required that it holds different kinds of asset classes. There are mainly four kinds of asset classes. Let us start unfolding those straight away-
1) Domestic Stocks
These are known for having the highest rate of return historically. They are included in the portfolio to make it growth-oriented. But these equities also come with a higher risk in the short run.
The more time to recover from market swings for a portfolio, the more advisable it is to invest in them.
These are also known as fixed-income securities. They are known for providing stability to the portfolio. These are safer and less risky than stocks. When the market goes down, they tend to do well. The interest paid by borrowers for the loan is the return.
Government treasuries and bonds are considered the safest. Their relatively lower rate of return is the trade-off for their security. On the other hand, corporate bonds, also known as junk bonds, are low quality but high return bonds.
3) Short-Term Investments
These are known for their function of preserving capital. These include a short-term certificate of deposit accounts and money market funds. Federal Deposit Insurance Corporation or FDIC covers CDs.
These are also known for their safety with earning slightly more than that of savings account. It is because the holder of CD, unlike a savings account, cannot move the money for a specific time.
Money market funds also provide a better rate of return than a savings account. Federal Deposit Insurance Corporation does not cover these. These can lose value which happened at the time of the Great Recession. But generally, the risk is considered negligible.
4) Foreign Stocks
International equities are generally known for their high returns and high risks. Their markets may not be affected by the domestic setbacks, and therefore they can assure stability in case of volatilities in the local markets.
They often have a small percentage in the diversified portfolios in general.
5) Real Estate Investment Funds
These investments usually perform better in the high inflation periods. These are mutual funds specializing in real estate investment trusts and public real estate companies.
These are the most accessible means to expose oneself to the real estate sector.
What are the Diversification within Asset Classes
There are also different types within an asset class. The main aim is to spread the risk and maximize returns. Below are the different types:
1) Mutual Funds
Since people’s money is pooled and invested in various places; mutual funds are automatically diversified in nature. Based on the company size, they can be large-cap, mid-cap or small-cap. Based on the investment risk profile, they can be conservative, moderate or aggressive.
Some mutual funds are index funds, that is, they are pegged to specific indices such as the S&P 500. They can be balanced or blended and hold different asset classes such as stocks and bonds.
2) Exchange-Traded Funds (ETFs)
Their functioning is similar to index funds. These can be traded like a stock. These can also be bought or sold throughout the day by changing their prices.
3) Target-Date Funds (TDFs)
These are also known as lifecycle funds. They are capable of changing their allocation of assets based on the age of the investor. With increasing investor’s change, they shift from more growth-oriented instruments towards fixed-income instruments.
There are many positive sides to diversification. But there are negative sides too. It can be more time consuming if a portfolio has too many holdings.
It is also expensive because the process of buying and selling involves different kinds of transaction expenses and commissions to brokers. Also, there are chances of decreasing the rewards in case a beneficial holding is given lesser weight.
Suppose a user has invested $120,000 among six stocks equally. One holding doubles in value. Your original invested $20,000 in that holding which is now $40,000 worth. But since you have spent $ 120,000 in different kinds of instruments, a few of them might be exposed to losses also.
By covering the investments from risks, the user is preventing his returns from getting doubled due to diversification.
Advantages of Diversification
- Reduced risk of loss for your overall portfolio or capital
- Hedged against market volatility, plus exposes you to different opportunities for return
- Higher returns in long-term
- Secures you from different adverse market cycles
Disadvantages of Diversification
- Limited gains in short-term
- Management is time-consuming
- Transaction fees, commissions incurred
Important factors of diversification
1. Types of investments
An investor must thoroughly examine the type of investment he wants to make before making any decision. These depend upon various factors such as amount, time, age, etc. It also includes multiple classes of assets such as stocks, bonds, cash, options, ETFs, etc.
2. Risk levels
It should be kept in mind that the portfolio should consist of the instruments with minimum levels of risk. Devices with dissimilar and different risk levels allow smooth gains and losses.
Investments should always be made in companies from different sectors and distinct industries. It is because the stocks of companies in various sectors and industries show a lower correlation.
4. Foreign markets
An investor should also consider foreign markets to invest, along with domestic markets. It is because there are high chances that the financial instruments traded in foreign markets are correlated less with the instruments traded in the domestic markets.
So, this was all about the concepts of diversifications and their implementations in reducing the risks of businesses. It is essential in empowering a company to appreciate sustainable growth and profitable existence.
Diversification Wrap Up!
There is no right or wrong answer to the question ‘what is the perfect amount of diversification?’ An investor might find it luring to continue to invest as long as several uncorrelated instruments are available in the market.
Given are the following factors which an investor may consider while creating a diversified portfolio-
How important do you consider diversification for the successful channelization of your business? Update us with your opinion in the comments below.
Do you want to know the right kind of diversification for your business? Then share your business details with our team, and they will guide in the process.