Diversification
Investment portfolios of a broad spectrum are subject to risks. Diversification is a strategy that helps manage those risks through a combination of different types of assets and investment instruments, limiting exposure to any one asset or risk.
Portfolio diversification is designed for higher long-term profits and lower risk of each individual asset or security. For this strategy, the portfolio is made up of different types of assets.
Understanding Diversification
In terms of mathematical research and modeling, a diversified portfolio of 25-30 stocks provides the most effective risk reduction. The greater the number of securities in a portfolio, the greater the benefits of diversified investing, but to a lower degree.
Diversification is good because the instruments in the portfolio respond differently to market influences. Thus, diversification provides a balance between the positive results of some investments and the negative results of others.
Diversification strategies
There are different ways and strategies to diversify assets. Below are some types of diversification strategies. Investors often use combinations of them within a single portfolio.
Asset Classes. Investments are often diversified by asset class. Investors or fund managers often divide a portfolio into shares because each asset class has its own advantages and risks. The asset classes can be:
- Stocks - shares or shares of a publicly traded company
- Bonds - debt instruments that have a fixed income from a government or corporation.
- Real estate - anything physical that a company owns (land, buildings, natural resources, agriculture, livestock, water and mineral resources).
- Exchange - traded funds (ETFs) - a set of securities following an index, commodity or market sector.
- Commodities - basic products for the production of other products and services.
- Cash and short-term cash-equivalents (CCE) - Treasury bills, certificates of deposit (CDs), low-risk short-term investments and other money market instruments.
Theoretically, a negative effect for one asset class could be a positive effect for another. Bond prices should generate increasing returns for fixed-income securities to become more attractive. But bonds are very dependent on changes in interest rates. The higher the interest rate, the lower the bond prices. In the same way, higher interest rates can lead to higher prices for commodities, real estate and rental housing.
Industries/Sectors
The operation of different industries or sectors varies greatly. The more diversified the investments, the less impact of industry market risks.
Investors diversify stocks across industries to balance different types of businesses. For example, investing in the 2 main types of entertainment businesses, unrelated to each other to minimize portfolio risk. At the risk of a massive pandemic in the future, investing in digital streaming platforms will help (lockdown will have a positive impact). If normal operating, airline investing can be developed (negative impact of lockdowns).
Corporate lifecycle stages (growth vs. value)
Basically, there are 2 categories of publicly traded stocks: growth stocks (company earnings are expected to grow) and value stocks (trading at a discount because of company fundamentals).
Expectations of the company's earnings growth may not come true, so growth stocks are more risky. For example, when monetary policy is restricted, loans become more costly (the available amount of capital becomes less). This makes it difficult for companies to grow.
More stable established companies bring less risk, so they represent value stocks. With a combination of both, an investor has the opportunity to take advantage of the existing strengths of one company and profit from the future potential of the other.
Market capitalizations (large vs. small)
The underlying market capitalization of a company or asset can play a major role in choosing to invest in various securities.
Generally, low-cap stocks have more growth prospects, and high-cap stocks have greater protection against investment risks.
Risk profiles
Every asset class has a risk profile. Investors choose and evaluate it. For example, for fixed-income securities, the issuer, its credit rating, business prospects and existing debt levels are important considerations.
It's the same for other types of investments. For example, the risks of investing in real estate projects are much higher than the risks of investing in cryptocurrencies, which have been on the market longer and have broader market coverage. But the growth prospects will be higher for real estate projects than for cryptocurrencies.
Maturity lengths
Different maturities of fixed-income securities affect different risk profiles. For example, the longer a bond's maturity, the greater the risk of changes in bond prices due to fluctuations in interest rates. Short-term bonds typically have lower interest rates, but they are also affected by uncertain future returns. Maturity is also important in other asset classes.
Physical locations (foreign vs. domestic)
By diversifying investments in foreign securities, it is possible to get additional benefits. Because events occurring in one country may not have an economic impact on another country.
When diversifying investments in developed and developing countries, it is possible to get more growth potential (the risk also increases).
Tangibility
Shares and bonds are basic financial instruments. They do not exist physically like land, real estate, farmland, precious metals or commodities. Tangible investments are assets with different investment profiles that can be applied in the real world.
Tangible assets have their own unique risks. They can be vandalized, physically stolen, damaged by natural conditions, obsolete, and may require storage, insurance or security costs.
