What is Diversification?
Definition: The level of risk that an investment portfolio is exposed to can be managed through diversification. It is also possible to enhance investment returns by diversifying your holdings. A diversified investment portfolio is one that deploys its funds in different financial securities and a range of asset classes.
What does Diversification mean?
The objective of every investor is to enhance returns while minimizing the level of risk. It is possible to do this by diversifying your investment holdings. It is highly risky to put all your money into the stock of a single company. If that firm incurs losses, the value of its stock may fall steeply.
Instead, it is advisable to diversify. Buy shares in 15 or 20 different companies. When you diversify your portfolio in this manner, it is preferable to choose firms that operate in separate industries. For example, you could purchase stock in firms that are engaged in sectors such as:
⇨ Information technology
If you diversify your portfolio in this manner, it is unlikely that you will see a fall in stock valuations in all the companies that you have invested in. A part of your portfolio may lose value while some stocks could see an increase in their prices.
But what if the entire stock market falls? That happened at the time of the global financial crisis. The S&P 500, a broad-based American stock market index, lost about 38% of its value in 2008. Many stocks saw a vast decline in prices. In a situation like this, diversifying your portfolio by buying shares in different companies may not have helped to preserve the value of your portfolio.
A better diversification strategy would have been to buy into different asset classes. A well-diversified investment portfolio consists of:
⇨ American stocks
⇨ Emerging market stocks
⇨ Real estate
Example of Diversification
Sean Kelly, an individual investor, has $225,000 to invest. He wants to build a diversified portfolio that will help him to maximize returns while preserving the value of his capital. His financial adviser suggests that the money is deployed in the following manner:
⇨ FAANG stocks (Facebook, Apple, Amazon, Netflix, and Alphabet, which is Google’s parent): $25,000
⇨ Other American equities: $50,000
⇨ Fidelity International Real Estate Fund: $50,000
⇨ iShares National Muni Bond ETF: $50,000
⇨ Vanguard FTSE Emerging Markets ETF: $25,000
⇨ SPDR Gold Shares (an ETF that invests in gold bullion): $25,000
This diversified portfolio provides exposure to American equities, emerging market equities, bonds, real estate, and gold. According to Sean’s financial adviser, these investments can provide a good rate of return while ensuring that the principal amount remains reasonably safe.
It’s wise to diversify your investments. This can help to preserve your capital while providing you with the opportunity to earn a return on them. Additionally, diversification is a good method to manage your level of risk.