Diversification: What It Is, Why It Matters & How to Do ItDiversification is a market strategy that enables you to spread your money across a variety of assets and investments in pursuit of uncorrelated returns, hedging, and risk control.
Table of Contents
What is portfolio diversification?
Brief history of the modern portfolio theory
Why is diversification important?
An example of diversification at work
How to diversify your portfolio
Components of a diversified portfolio
Build wealth through diversification
Diversification vs concentration
Summary
📍 What is portfolio diversification?
Portfolio diversification is the strategy of spreading your money across diverse investments in order to mitigate risk, hedge and balance your exposure in pursuit of uncorrelated returns. While it may sound complex at first, portfolio diversification could be your greatest strength when you set out to trade and invest in the financial markets.
As a matter of fact, once you immerse yourself into the markets, you will be overwhelmed by the wide horizons waiting for you. That’s when you’ll need to know about diversification.
There are thousands of stocks available for trading, dozens of indices, and a sea of cryptocurrencies. Choosing your investments will invariably lead to relying on diversification in order to protect and grow your money.
Diversifying well will enable you to go into different sectors, markets and asset classes. Together, all of these will build up your diversified portfolio.
📍 Brief history of the modern portfolio theory
“ Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim. ” These are the words of the father of the modern portfolio theory, Harry Markowitz.
His paper on diversification called “Portfolio Selection” was published in The Journal of Finance in 1952. The theory, which helped Mr. Markowitz win a Nobel prize in 1990, posits that a rational investor should aim to maximize their returns relative to risk.
The most significant feature from the modern portfolio theory was the discovery that you can reduce volatility without sacrificing returns. In other words, Mr. Markowitz argued that a well-diverse portfolio would still hold volatile assets. But relative to each other, their volatility would balance out because they all comprise one portfolio.
Therefore, the volatility of a single asset, Mr. Markowitz discovered, is not as significant as the contribution it makes to the volatility of the entire portfolio.
Let’s dive in and see how this works.
📍 Why is diversification important?
Diversification is important for any trader and investor because it builds out a mix of assets working together to yield returns. In practice, all assets contained in your portfolio will play a role in shaping the total performance of your portfolio.
However, these same assets out there in the market may or may not be correlated. The interrelationship of those assets within your portfolio is what will allow you to reduce your overall risk profile.
With this in mind, the total return of your investments will depend on the performance of all assets in your portfolio. Let’s give an example.
📍 An example of diversification at work
Say you want to own two different stocks, Apple (ticker: AAPL ) and Coca-Cola (ticker: KO ). In order to easily track your performance, you invest an equal amount of funds into each one—$500.
While you expect to reap handsome profits from both investments, Coca-Cola happens to deliver a disappointing earnings report and shares go down 5%. Your investment is now worth $475, provided no leverage is used.
Apple, on the other hand, posts a blowout report for the last quarter and its stock soars 10%. This move would propel your investment to a valuation of $550 thanks to $50 added as profits.
So, how does your portfolio look now? In total, your investment of $1000 is now $1,025, or a gain of 2.5% to your capital. You have taken a loss in Coca-Cola but your profit in Apple has compensated for it.
The more assets you add to your portfolio, the more complex the correlation would be between them. In practice, you could be diversifying to infinity. But beyond a certain point, diversification would be more likely to water down your portfolio instead of helping you get more returns.
📍 How to diversify your portfolio
The way to diversify your portfolio is to add a variety of different assets from different markets and see how they perform relative to one another. A single asset in your portfolio would mean that you rely on it entirely and how it performs will define your total investment result.
If you diversify, however, you will have a broader exposure to financial markets and ultimately enjoy more probabilities for winning trades, increased returns and decreased overall risks.
You can optimize your asset choices by going into different asset classes. Let’s check some of the most popular ones.
📍 Components of a diversified portfolio
Stocks
A great way to add diversification to your portfolio is to include world stocks , also called equities. You can look virtually anywhere—US stocks such as technology giants , the world’s biggest car manufacturers , and even Reddit’s favorite meme darlings .
Stock selection is among the most difficult and demanding tasks in trading and investing. But if you do it well, you will reap hefty profits.
Every stock sector is fashionable in different times. Your job as an investor (or day trader) is to analyze market sentiment and increase your probabilities of being in the right stock at the right time.
Currencies
The forex market , short for foreign exchange, is the market for currency pairs floating against each other. Trading currencies and having them sit in your portfolio is another way to add diversification to your market exposure.
Forex is the world’s biggest marketplace with more than $7.5 trillion in daily volume traded between participants.
Unlike stock markets that have specific trading hours, the forex market operates 24 hours a day, five days a week. Continuous trading allows for more opportunities for price fluctuations as events occurring in different time zones can impact currency values at any given moment.
Cryptocurrencies
A relatively new (but booming) market, the cryptocurrency space is quickly gaining traction. As digital assets become increasingly more mainstream, newcomers enter the space and the Big Dogs on Wall Street join too , improving the odds of growth and adoption.
Adding crypto assets to your portfolio is a great way to diversify and shoot for long-term returns. There’s incentive in there for day traders as well. Crypto coins are notorious for their aggressive swings even on a daily basis. It’s not unusual for a crypto asset to skyrocket 20% or even double in size in a matter of hours.
But that inherent volatility holds sharpened risks, so make sure to always do your research before you decide to YOLO in any particular token.
Commodities
Commodities, the likes of gold ( XAU/USD ) and silver ( XAG/USD ) bring technicolor to any portfolio in need of diversification. Unlike traditional stocks, commodities provide a hedge against inflation as their values tend to rise with increasing prices.
Commodities exhibit low correlation with other asset classes, too, thereby enhancing portfolio diversification and reducing overall risk.
Incorporating commodities into a diversified portfolio can help mitigate risk, enhance returns, and preserve purchasing power in the face of inflationary pressures, geopolitical uncertainty and other macroeconomic risks.
ETFs
ETFs , short for exchange-traded funds, are investment vehicles which offer a convenient and cost-effective way to gain exposure to a number of assets all packaged in the same instrument. These funds pull a bunch of similar stocks, commodities and—more recently— crypto assets , into the same bundle and launch it out there in the public markets. Owning an ETF means owning everything inside it, or whatever it’s made of.
ETFs typically have lower expense ratios compared to mutual funds, making them affordable investment options.
Whether you seek broad market exposure, niche sectors, or thematic investing opportunities, ETFs are a convenient way to build a diversified portfolio tailored to your investment objectives and risk preferences.
Bonds
Bonds are fixed-income investments available through various issuers with the most common one being the US government. Bonds are a fairly complex financial product but at the same time are considered a no-brainer for investors pursuing the path of least risk.
Bonds have different rates of creditworthiness and maturity terms, allowing investors to pick what fits their style best. Bonds with longer maturity—10 to 30 years—generally offer a better yield than short-term bonds.
Government bonds offer stability and low risk because they’re backed by the government and the risk of bankruptcy is low.
Cash
Cash may seem like a strange allocation asset but it’s actually a relatively safe bet when it comes to managing your own money. Sitting in cash is among the best things you can do when stocks are falling and valuations are coming down to earth.
And vice versa—when you have cash on-hand, you can be ready to scoop up attractive shares when they’ve bottomed out and are ready to fire up again (if only it was that easy, right?).
Finally, cash on its own is a risk-free investment in a high interest-rate environment. If you shove it into a high-yield savings account, you can easily generate passive income (yield) and withdraw if you need cash quickly.
📍 Build wealth through diversification
In the current context of market events, elevated interest rates and looming uncertainty, you need to be careful in your market approach. To this end, many experts advise that the best strategy you could go with in order to build wealth is to have a well-diversified portfolio.
“ Diversifying well is the most important thing you need to do in order to invest well ,” says Ray Dalio , founder of the world’s biggest hedge fund Bridgewater Associates.
“ This is true because 1) in the markets, that which is unknown is much greater than that which can be known (relative to what is already discounted in the markets), and 2) diversification can improve your expected return-to-risk ratio by more than anything else you can do. ”
📍 Diversification vs concentration
The opposite of portfolio diversification is portfolio concentration. Think about diversification as “ don’t put your eggs in one basket. ” Concentration, on the flip side, is “ put all your eggs in one basket, and watch it carefully. ”
In practice, concentration is focusing your investment into a single financial asset. Or having a few large bets that would assume higher risk but higher, or quicker, return.
While diversification is a recommended investment strategy for all seasons, concentration comes with bigger risks and is not always the right approach. Still, at times when you have a high conviction on a trade and have thoroughly analyzed the market, you may decide to bet heavily, thus concentrating your investment.
However, you need to be careful with concentrated bets as they can turn against your portfolio and wreck it if you’re overexposed and underprepared. Diversification, however, promises to cushion your overall risk by a carefully balanced approach to various financial assets.
📍 Summary
A diversified portfolio is essentially your best bet for coordinated and sustainable returns over the long term. Choosing a mix of various types of investments, such as stocks, ETFs, currencies, and crypto assets, would spread your exposure and provide different avenues for growth potential. Not only that, but it would also protect you from outsized risks, sudden economic shocks, or unforeseen events.
While you decrease your risk tolerance, you raise your probability of having winning positions. Regardless of your style and approach to markets, diversifying well will increase your chances of being right. You can be a trader and bet on currencies and gold for the short term. Or you can be an investor and allocate funds to stocks and crypto assets for years ahead.
Potential sources of diversification are everywhere in the financial markets. Ultimately, diversifying gives you thousands of opportunities to balance your portfolio and position yourself for risk-adjusted returns.
🙋🏾♂️ FAQ
❔ What is portfolio diversification?
► Portfolio diversification is the strategy of spreading your money across diverse investments in order to mitigate risk, hedge and balance your exposure in pursuit of uncorrelated returns.
❔ Why is diversification important?
► Diversification is important for any trader and investor because it creates a mix of assets working together to yield high, uncorrelated returns.
❔ How to diversify your portfolio?
► The way to diversify your portfolio is to add a variety of different assets and see how they perform relative to one another. If you diversify, you will have a broader exposure to financial markets and ultimately enjoy more probabilities for winning trades, increased returns, and decreased overall risks.
Do you diversify? What is your strategy? Do you rebalance? Let us know in the comments.
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