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Diversification is an investment strategy that involves allocating capital across a variety of asset and sub-asset classes. The goal of diversification is to maximize returns while minimizing portfolio risk.
Diversification works by spreading investments across different types of assets that tend to perform differently under the same market conditions. When some assets in a portfolio decline, others may increase or hold steady, helping to offset some of the losses and smooth out volatility over time.
Diversification capitalizes on the low or negative correlation between asset classes. Correlation is a statistical concept that refers to the degree of similarity between the behavior of one variable compared to another.
For example, when stock prices fall, bond prices tend to rise and vice versa. By combining assets with low correlation in a given portfolio, losses in one area can be compensated to some degree by the gains that other areas of the portfolio produce during the same period.
Optimal volatility is a concept that can hardly be achieved as the degree to which a portfolio should be diversified depends on investors’ individual and often unique characteristics, including their financial goals, risk tolerance, employment situation, and income.
However, some models, like Modern Portfolio Theory (MPT), have emerged to allow investors to determine the ‘optimal’ allocation for a group of assets. This is the specific weight assigned to each that produces the highest return for a given level of risk.
While diversification itself does not have a specific calculation, portfolio risk metrics like standard deviation can quantify the impact of diversification on a portfolio’s performance.
Standard deviation measures historical volatility.
A low standard deviation indicates lower volatility. Comparing the standard deviations of an undiversified portfolio to its diversified counterpart illustrates diversification’s risk-reduction impact.
Other helpful metrics include the Sharpe ratio, which measures returns adjusted for risk, and R-squared, which gauges the percentage of one investment’s performance explained by another. Effective diversifiers will have low R-squared values relative to other portfolio assets.
Diversification protects investors from experiencing large losses, the impact of industry-specific events, and stock-picking risks.
By spreading capital across many assets, investors avoid overexposure to the risks associated with investing in a single security. For example, investors with a portion of assets in Enron stock during its collapse would have faced less damage if they had invested in other stocks as well.
Offsetting the gains and losses produced by non-correlated assets dampens portfolio volatility across market cycles. This helps investors rely less on market timing by staying invested through various boom and bust phases.
Big drawdowns can drag a portfolio’s performance and an investor’s account balance to extremely low levels. During bear markets, individual stocks and sectors are often disproportionately damaged. By diversifying accordingly, investors can reduce drawdowns through their exposure to areas of the market that typically thrive during recessionary cycles.
Investors who are uncomfortable with assuming certain levels of risk can define the optimal allocation and diversification strategy that delivers the kind of results they expect in terms of both returns and volatility.
Blending non-correlated return streams with standalone risk profiles improves return potential per unit of risk taken. Losses become less painful when accompanied by offsetting asset gains.
The most popular diversification strategies involve the use of various asset and sub-asset classes to mitigate risks while generating decent returns at the same time.
Here’s a summary of the most popular techniques used by investors to diversify their portfolios.
A simple diversified portfolio could contain the following asset classes and respective weights:
Meanwhile, a more sophisticated and complex example of a diversified investment portfolio may be:
Diversification is great in most cases but there are also a few disadvantages of this financial practice that investors must take into account.
Diversification is a strategy that any investor can tap into to manage portfolio risks. By spreading assets across multiple classes and sub-classes with low or negative correlations, volatility can be smoothed without necessarily sacrificing returns.
Diversification allows riding out storms that disproportionately impact individual asset classes. For long-term investors, diversification provides an accessible path toward improved risk-adjusted performance.
Diversification reduces portfolio volatility and risks over time by incorporating non-correlated asset classes or securities that perform differently under the same circumstances. The gains produced by one area of the portfolio during a given period are used to offset the losses generated by underperforming assets during that same time.
A typical portfolio diversification strategy is known as ‘stocks and bonds’. It involves investing a fixed percentage in each asset class. The weight assigned to each will vary depending on the investors’ risk tolerance and financial goals. Risk takers will often increase the stock component beyond 60% of the portfolio, while cautious investors or income-seeking individuals will invest primarily in bonds as they generate interest income and their principal value is less volatile.
The asset diversification rule explains the specific weight assigned to each asset class and sub-class that will be added to the portfolio. This rule must be followed at all times. Depending on how these assets perform, periodical rebalancing will be required to maintain the portfolio’s target allocations in line with these defined rules.
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Alejandro has seven years of experience writing content for the financial industry and more than 17 years of combined work experience, serving under different roles in multiple business fields including tech and financial services. Before joining Techopedia, Alejandro collaborated with numerous online publications such as Seeking Alpha, The Modest Wallet, Capital.com, Business2Community, EconomyWatch.com, and others, covering finance, business news, trading platform reviews, and educational articles for investors. Alejandro earned a Bachelor's in Business Administration from UNITEC, Venezuela, and a Master's in Corporate Finance from EUDE Business School, Spain. His favorite topics to cover are value investing and financial analysis.
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