What is Diversification?

A portfolio’s investments are mixed in a wide variety as part of the risk management approach is also known as diversification. To reduce exposure to any one asset or risk, a diversified portfolio combines a variety of different asset classes and investment vehicles. This strategy is justified by the idea that a portfolio made up of various asset classes will, on average, produce superior long-term returns and reduce the risk of any given holding or security.

By investing in both international and domestic markets, portfolio holdings can be diversified not just across asset classes but also within classes. The notion is that a portfolio’s strong performance in one area will balance out any weaknesses in another.

The Basics of Diversification

Research and mathematical models have demonstrated that the highest cost-effective level of risk reduction is achieved by maintaining a well-diversified portfolio of 25 to 30 stocks. Even though they occur at a much slower rate, additional benefits of diversification are nevertheless produced by investing in more stocks.

In order for the beneficial performance of some assets to offset the bad performance of others, diversification aims to smooth out unsystematic risk occurrences in a portfolio. The benefits of diversification only apply if the assets in the portfolio are not fully correlated; in other words, if they react to market factors differently, frequently in opposite directions.

Diversification by Asset Class

Asset Class Diversification Fund managers and investors frequently diversify their holdings across asset classes and decide what proportions of the portfolio to allocate to each. Some classes include:

  • Real estate includes land, buildings, natural resources, agriculture, livestock, water, and mineral deposits.
  • Exchange-traded funds (ETFs) are a marketable basket of securities that track an index, commodity, or sector.
  • Commodities are basic goods required for the production of other goods and services.
  • Stocks are shares or equity in a publicly traded company.
  • Bonds are government and corporate fixed-income debt instruments.
  • Cash and short-term cash equivalents (CCE) such as Treasury bills, CDs, money market instruments, and other short-term, risk-free assets

Then, they will diversify their holdings within the asset classes by, for example, buying equities from different industries that often have low return correlation or firms with varying market capitalizations. Investment-grade corporate bonds, U.S. Treasuries, state and municipal bonds, high-yield bonds, and other options are available to investors when it comes to bonds.

Diversity of Immigration

By investing in international assets, which often have lower correlations with domestic ones than domestic ones, investors can further increase the benefits of diversification. For instance, factors affecting the U.S. economy may not have the same impact on Japan’s economy. Therefore, owning Japanese equities provides a minimal level of loss protection during a downturn in the American economy.

Retail Investors and Diversification

It can be challenging for noninstitutional investors, or individuals, to build a portfolio that is sufficiently diversified due to time and financial constraints. This difficulty is a major factor in the appeal of mutual funds to regular investors. Investing in shares in a mutual fund is a cheap approach to diversifying your portfolio.

Exchange-traded funds (ETFs) give investors access to niche markets like commodities and international bets that would otherwise be difficult to access, whilst mutual funds offer diversification across numerous asset classes. With no overlap, a person with a $100,000 portfolio can distribute their investment among ETFs.

Benefits and Drawbacks of Diversification

lowered risk and a cushion for volatility Diversification have several benefits. There are disadvantages, though. A portfolio can be more time-consuming to manage and more expensive as it becomes more expensive to buy and sell a variety of holdings due to higher transaction costs and brokerage commissions. Fundamentally, diversification lowers both the risk and the profit by using a spreading-out method.

Let’s imagine that you split your $120,000 among six equities, and one of them doubles in value. Your initial stake of $20,000 is now worth $40,000 in total. Sure, you’ve made a lot, but not as much as if you’d put your entire $120,000 into that one business. Diversification restricts your upward potential while safeguarding your downside—at least temporarily. Diversified portfolios do typically produce superior returns over the long term (see example below).

Benefits:

  1. Lowers portfolio risk.
  2. Protects against market volatility.
  3. Provides higher returns. long-term.

Drawbacks

  1. Short-term returns are limited.
  2. Management is time-consuming.
  3. More transaction costs and commissions.

Broadening and Smart Beta

By following underlying indices, smart beta strategies provide diversity but may not always weigh equities according to their market capitalization. ETF managers also conduct a fundamental screening of equity issues and rebalance portfolios based on objective analysis rather than merely company size. Although smart beta portfolios are unmanaged, outperformance of the index itself becomes their main objective.

The iShares Edge MSCI USA Quality Factor ETF, for instance, contains 125 large- and mid-cap U.S. companies as of March 2019. The ETF has produced a cumulative return of 90.49 percent since its debut in July 2013 by focusing on return on equity (ROE), debt-to-equity (D/E) ratio, and not only market cap. An investment of a similar size in the S&P 500 Index increased by 66.33 percent.

Real-world Case Study

Imagine that a risk-tolerant, aggressive investor wants to build a portfolio that includes cotton futures, Australian bonds, and Japanese shares. He may decide to invest in securities such as the iShares MSCI Japan ETF, the Vanguard Australian Government Bond Index ETF, and the iPath Bloomberg Cotton Subindex Total Return ETN, for instance.

Due to the unique characteristics of the targeted asset classes and the transparency of the holdings, the investor can guarantee real diversification in their holdings with this combination of ETF shares. Additionally, they can modestly reduce their risk exposure because of the varying correlations, or responses to outside forces, among the securities. (See “The Importance Of Diversification” for supplementary reading.)

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