How Diversification May Help To Minimize Risks And Optimize Returns?
Diversification is an important investment strategy with the objective of reducing the overall risk of a portfolio. It involves different strategies of capital allocation with the aim to minimize potential losses and increase returns.
This article will discuss the concept of diversification, it’s benefits, and the techniques that can be used to achieve more stable returns over time.
Key takeaways
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Diversification is an investment strategy that involves spreading investments across different asset classes, industries, and geographic regions to reduce overall risk.
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Diversification strives to smooth out unsystematic risk events by balancing the positive performance of some investments with the negative performance of others.
Diversification explained
Diversification is an investor’s tool for reducing risk and optimizing returns by spreading investments across a variety of asset classes, industries, and geographic regions. It is a way of managing a portfolio so as to reduce the overall risk of the investment.
A diversified portfolio typically contains a mix of stocks, bonds, real estate, and cryptocurrency. Diversification can also be done by investing in different countries, industries, sizes of companies, or term lengths for income-generating investments.
The quality of diversification is measured by analyzing the correlation coefficient of pairs of assets. Studies have shown that a diversified portfolio of 25-30 stocks yields the best risk reduction.
Diversification works by smoothing out unsystematic risk events in a portfolio, so the positive performance of some investments offsets the negative performance of others. This only works if the securities in the portfolio are not perfectly correlated.
Geographical diversification, which is investing across geographic regions, is another way of reducing risk and improving returns. Unsystematic risk, which is company-specific risk, can be reduced through diversification.
Maximum portfolio diversification is achieved by investing in different asset classes, such as stocks, bonds, and commodities, and by investing in foreign companies instead of just domestic firms. Over-diversification, however, can lead to confusion, increase investment costs, and lead to lower risk-adjusted returns.
Diversification is a common strategy used to minimize the chances of experiencing large losses. It is a key portfolio management technique when executed properly.
If you want to know what the 5% rule is in portfolio management, read the Traders Union article.
Related terms for beginners
What other terms related to diversification should beginners be aware of?
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Assets correlation - the relationship between the prices of two assets, such as stocks or bonds.It can be used to determine how much diversification is necessary, as investments that are highly correlated are not good candidates for diversification.
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Portfolio variance (volatility) - the degree to which the value of a portfolio’s investments deviate from its average over time. It helps investors determine how much risk they are willing to take on and how to best manage their portfolio to achieve their goals.
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Risk tolerance - investor's ability and willingness to accept declines in the value of their investment portfolio. It is a measure of how much volatility an investor can endure in pursuing their financial goals.
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Maturity lengths refer to the amount of time until a financial instrument, most commonly a bond or fixed deposit, reaches its "maturity date" and the principal amount is repaid to the investor.
How does diversification work?
Building on the related terms discussed previously, diversification works by creating a portfolio of investments with low asset correlation and appropriate risk tolerance that matures at appropriate lengths. It involves spreading investments across different asset classes, geographic regions, industries, and companies of different sizes. To reduce risk and improve returns, geographical diversification involves investing in securities from different regions. Strategically, diversification can be approached through asset diversification, sector diversification, and geographical diversification.
Asset diversification spreads investments among different asset classes, like stocks, bonds, real estate, and cryptocurrencies.
Sector diversification involves investing across various industries to avoid the downfall of a single sector.
Geographical diversification mitigates the risks associated with the economic volatility of a specific region by investing in assets from various countries and continents.
In practice, techniques such as Dollar-Cost Averaging (DCA), rebalancing, and hedging are essential components of effective diversification. DCA involves regularly investing a fixed amount of money, reducing the impact of volatility.
Rebalancing ensures your portfolio maintains its desired asset allocation, adjusting the proportion of assets as needed.
Hedging, another sophisticated technique, employs alternative investments or derivatives to counteract potential losses in a portfolio.
The quality of diversification is assessed by the correlation coefficient between pairs of assets. A well-diversified portfolio will feature investments that do not move in perfect synchrony. While diversification aims to balance risk, it's vital to avoid over-diversification, as holding too many assets can lead to average returns that do not sufficiently compensate for risk taken.
Ultimately, when executed mindfully, diversification stands as an invaluable strategy for reducing unsystematic risk and enhancing the resilience of your investment portfolio. Read also: How to Build an Investment Portfolio in 6 steps in the TU article.
Examples of diversification
Warren Buffett - Berkshire Hathaway. Diversification Across Industries.
Warren Buffett's investment conglomerate, Berkshire Hathaway, holds a diversified portfolio spanning various sectors, for example:
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Technology: significant stake in Apple Inc;
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Financial: Bank of America, American Express, Moody's;
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Consumer staples: the Coca-Cola Company and Kraft Heinz;
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Energy: Chevron, Occidental Petroleum;
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Airlines: previously held stakes in major U.S. airlines, though these were sold in 2020.
Ray Dalio - Bridgewater Associates. Diversification Across Asset Classes.
Ray Dalio, the founder of Bridgewater Associates, is known for his "All Weather" investment strategy, which aims to produce steady returns regardless of market conditions:
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Equities: investments in various global stocks;
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Bonds: holdings in government and corporate bonds;
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Commodities: investments in gold and other commodities;
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Inflation-Protected Bonds: TIPS (Treasury Inflation-Protected Securities).
Dalio's approach emphasizes diversification based on the economic environment and its potential impact on different asset classes. By balancing assets that might perform well in different scenarios (e.g., inflation, recession), the "All Weather" strategy seeks to achieve consistent returns.
Both Warren Buffett and Ray Dalio are legendary investors, and their investment strategies, while distinct, underscore the importance of diversification in managing risk and achieving steady returns.
However, it is important to remember that:
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The benefits of diversification only hold if the securities in the portfolio are not perfectly correlated;
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Over-diversification can lead to confusion and weaker-than-expected risk-adjusted returns.
Consulting a financial advisor can ensure proper diversification of the portfolio.
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FAQs
How many stocks should I hold for a diversified portfolio?
There's no one-size-fits-all number, but a common suggestion is holding between 15 and 30 stocks across various sectors to achieve effective diversification. However, the exact number can vary depending on individual risk tolerance and investment goals.
Can I diversify with a small investment portfolio?
Yes, even with a small portfolio, you can achieve diversification by investing in mutual funds or exchange-traded funds (ETFs), which provide exposure to a broad range of assets, sectors, or geographies with a relatively small amount of capital.
Can diversification help during a market downturn?
Diversification can mitigate losses during a market downturn as not all asset classes, sectors, or regions move down at the same time or at the same rate. Still, it can’t guarantee complete protection against losses.
What type of risk cannot be eliminated by diversification?
Systematic risk, also known as market risk, cannot be eliminated through diversification as it affects the entire market or a specific segment of the market and is linked to factors like inflation rates, political events, or economic downturns.
Team that worked on the article
Vuk stands at the forefront of financial journalism, blending over six years of crypto investing experience with profound insights gained from navigating two bull/bear cycles. A dedicated content writer, Vuk has contributed to a myriad of publications and projects. His journey from an English language graduate to a sought-after voice in finance reflects his passion for demystifying complex financial concepts, making him a helpful guide for both newcomers and seasoned investors.
Dr. BJ Johnson is a PhD in English Language and an editor with over 15 years of experience. He earned his degree in English Language in the U.S and the UK. In 2020, Dr. Johnson joined the Traders Union team. Since then, he has created over 100 exclusive articles and edited over 300 articles of other authors.
The topics he covers include trading signals, cryptocurrencies, Forex brokers, stock brokers, expert advisors, binary options. He has also worked on the ratings of brokers and many other materials.
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Mirjan Hipolito is a journalist and news editor at Traders Union. She is an expert crypto writer with five years of experience in the financial markets. Her specialties are daily market news, price predictions, and Initial Coin Offerings (ICO). Mirjan is a cryptocurrency and stock trader. This deep understanding of the finance sector allows her to create informative and engaging content that helps readers easily navigate the complexities of the crypto world.