The Complete Guide to Portfolio Diversification

Portfolio Diversification

Having a strong investment strategy is fundamental to the realisation of your financial goals as an investor. This means adopting a plan that minimises your exposure to risks while leveraging returns. This is essentially what portfolio diversification seeks to achieve. By diversifying their investment portfolio, investors can establish a set of stable and profitable securities by avoiding and managing potential risks. Unfortunately, while portfolio diversification presents a wealth of growth opportunities and benefits, most investors have missed out on some fundamental aspects of this foundational investment strategy. This guide discusses the essentials of portfolio diversification and how the concept can help individual investors, regardless of the market.

What is Portfolio Diversification?

Portfolio diversification is an investment strategy that applies a mix of varying assets and securities to minimise risk and build on the performance of an investor’s portfolio. The rationale supporting this concept is that creating a portfolio of investments using different types of securities reduces the risks associated with an individual asset. As a result, the collective gain of the portfolio is a high-yield return in the long run.

Ideally, an investor’s portfolio will constitute assets and securities with minimal or even no correlation, lowering the exposure of shared risks. The objective is to enhance an overall stable portfolio with relatively high earning potential.

The Basics of Portfolio Diversification

The primary goal of portfolio diversification is to enhance a solid balance between the returns and risks linked to various investments. To understand the diversification concept fully, here are some elemental aspects that you must familiarise yourself with.

[1] Asset Class

This refers to a group of securities or investments exhibiting similar attributes and behaviors in a given financial market. Typically, securities within the same asset class are subject to shared risks. In this case, a portfolio with a broader range of asset classes is considered to have minimal exposure to risk, hence strongly diversified. The major asset classes available for diversification today include the following;

  • Equities or Stocks – Represent ownership equity as issued by publicly traded companies. Investors can gain from equities through annual dividends or by profiting from a variation in stock prices.
  • Fixed Income Securities – Refers to investments made in debt securities. Generally, investors generate returns from fixed income securities in the form of interest. Investments within this category are considered less risky than most of the other asset classes.
  • Cash and Cash Equivalents – These are assets readily convertible into a cash amount. Assets within this category are highly liquid. This is because cash and cash equivalents are designed to be ready for conversion into money close to their maturation.
  • Commodities and Real Estate – Assets within this class are known to protect your investment against inflation.

These and other asset classes are distributed across multiple investment sectors. This not only provides investors with varying channels to generate returns but also ensures that the risks associated with each asset class are distinct.

[2] Securities

A security is a financial instrument that can be traded in a private or public market to generate capital. Securities exist in three major categories, including debts, equities, and hybrid instruments. While debts represent loans repaid periodically at a given interest rate, equities constitute proportions of ownership in a corporation, company, or trust. On the other hand, hybrid securities apply a mix of attributes of equities and debt instruments.

[3] Market Fund

This is an investment vehicle designed to enable you invest in highly liquid securities using a single financial instrument. They include such vehicles as Exchange-Traded Funds (ETFs), bond indexes, and mutual funds.

[4] Correlation

Correlation is a foundational aspect of portfolio diversification. It refers to the degree of relationship between investments of varying asset classes featured in a portfolio. Depending on the strength of the relationship between two securities, correlation can be quantified as either positive or negative. For instance, when the price of an investment moves in tandem with the other, they are said to have a positive correlation. Conversely, when the prices of two securities move in opposite directions, a negative correlation is established.

When there is zero effect on the movement of a security’s price in relation to another, the investment is said to have a perfect correlation. Essentially, the lower the correlation of investments, the more diversified it is. Therefore, in most cases, investors will go for asset classes with perfect correlation when adopting portfolio diversification as an investment strategy.

Pros and Cons of Portfolio Diversification

By investing in a mix of securities from varied asset classes, investors can enjoy benefits or suffer risks in equal proportions. Here are some of the benefits and risks of diversifying your portfolio.

Pros

Reduced Portfolio Risk

Generally, any portfolio of investments is subject to facing two types of risks, namely systematic and unsystematic risks. Systematic risk is the overall risk inherent to a segment of the market or an entire market. Typically, systematic cannot be avoided through diversification. However, portfolio diversification comes in handy as a risk management strategy in minimising your exposure to systematic risk.

In contrast, unsystematic risk is the risk that is distinctively linked to specific securities. This type of risk can be mitigated and controlled through diversification.

Increase Risk-Adjusted Returns

While two portfolios may generate similar returns, a diversified portfolio is exposed to less risk in producing its yields. Therefore, diversification plays a critical role in increasing the risk-adjusted returns of your investments.

Leveraging Growth Opportunities

Diversification exposes you to a wide range of sectors and assets that may otherwise be beyond reach with concentrated investments. Financial markets are known for experiencing cycles where certain sectors and segments outperform others in terms of inflows and returns. This means that a worse performing sector today could be at the top of the table next year, and vice versa. With portfolio diversification, you can leverage the growth opportunities presented by these cycles.

Enhanced Financial Peace

A diversified portfolio is less susceptible to the impact of economic downturns and market volatility. Again, diversification promises stable returns with minimal exposure to risks. This way, you do not have to spend your time and efforts monitoring your portfolio against market volatility. The resulting benefit of this is peace of mind and emotional stability. You can refocus your energy and emotions on other important things while enjoying relatively good returns.

Cons

Overdiversification

One of the setbacks of diversification is the lack of a standard measure to determine when diversification is good enough. As a result, most investors tend to build a portfolio with disproportionate assets than they benefit from. Overdiversification can be too expensive to maintain, not forgetting dilution of returns and portfolio bloating associated with this move.

Complicated Investments

Asset classes differ in nature and structure. Therefore, to successfully benefit from various asset classes, investors must understand how each asset class works and the market dynamics involved. This demands more effort and time. Unfortunately, diversifying a portfolio with unknown assets has had most investors complicate their investments.

Tax Complications

Every asset class has its own way of going about taxation. For instance, the taxation structure of debt funds is significantly different from that of equity mutual funds. As a result, investors with little or no knowledge of the taxation requirements of various asset classes may be caught up in a state of confusion.

How to Diversify Your Portfolio Across Different Asset Classes

There are wide-ranging options when it comes to diversification strategies. One of the most common ways of diversifying investments is asset allocation. This means distributing your investments across different asset classes to reduce risks and leverage returns. Here is a guide on how to diversify your portfolio across asset classes.

Stocks

When adding stocks to a portfolio, investors must consider the following factors;

Industry or Sector

Stocks are defined on the basis of sectors or industries. In this case, consider buying stocks from companies distributed across multiple sectors. This is because market volatility impacts companies and individual stocks differently. For example, stocks from cyclical sectors like electronics and fashion tend to move in sync with the market cycles. On the other hand, defensive stocks are less impacted by any economic movement.

Size and Market Capitalisation

The size of a company must be a fundamental component to consider when diversifying your portfolio with stocks. Often, companies with large market capitalisation are known for withstanding economic downturns easily. However, their stocks are defined by limited growth opportunities and low yields. Conversely, small companies tend to deliver higher yields, but their stocks are associated with relatively high risks.

Growth and Value

The stage of a company’s lifecycle is also a critical factor to consider when choosing a stock to diversify your portfolio. The rationale behind this prospect is that there is a significant difference in risks and rates of returns between established companies and new corporations.

Bonds

Integrate bonds into your portfolio based on the following factors;

Issuer

Consider bonds from across different issuers, including Treasury Bonds, corporate bonds, and municipal bonds. Depending with the issuer, some bonds are considered safer than others.

Credit Risk

This is the risk that the bond issuer will default repaying the debt security. You may want to diversify your portfolio with bonds of varied credit risks. In this case, the Treasury bonds have the least credit risk, with various corporate bonds carrying the highest risk of defaulting.

Maturity

Bond maturity is the duration it will take to receive interest payments on a bond investment. Diversify your portfolio with long-term, intermediate, and short-term bonds. Ideally, the higher the maturation period of a bond, the greater the returns.

Stocks and Bonds

This is the leading asset class combination in the world of portfolio diversification. When building your portfolio with stocks and bonds, one of the key decisions you may have to make revolves around the geographical location of an entity.

The geographic location of an entity impacts the value of a bond and stock in terms of their exposure to growth opportunities. Generally, an entity is said to be located in a developed country, emerging markets, or the US market. Bonds and stocks from emerging and developed markets are known for their high yields and broad growth opportunities. However, such securities are highly susceptible to risks than assets sourced from US-based entities.

Alternative Asset Classes

Today, there are a lot more options of asset classes available to help you build a well-diversified portfolio. For example, in addition to bonds and stocks, you can integrate cryptocurrencies, commodities, real estate, or a mutual fund into your portfolio. Any of these alternative asset classes can go a long way in increasing the potential returns of your investments while lowering your exposure to risks.

When is Diversification Helpful to Retail Investors?

All the financial markets are vulnerable to certain levels of systematic and unsystematic risks. However, these markets do not suffer economic downturns and volatility at the same time. So, what necessitates diversification, and when should you diversify your portfolio?

Risk Tolerance

If you cannot withstand the frustration of experiencing your portfolio losing on a day-to-day basis, then it might be the right time to diversify your investments. While portfolio diversification may slow your speed of achieving specified financial goals, you will not have to worry about extreme exposure to risks.

Wealth Building

Investors interested in building wealth may find portfolio diversification to be an essential component of their investments. This is because diversifying your investments introduces you to a wealth of high-yielding opportunities that you may never have access to with a concentrated portfolio. Again, diversification enhances a more stable portfolio, enhancing high returns and reduced risks.

Market Knowledge

Investors with expansive knowledge about various financial markets are more likely to benefit from portfolio diversification. Understanding how different asset classes work is enough reason why you should diversify your investments.

Wrap up

Portfolio diversification is a great investment strategy. There is no better way to enjoy a high return on your investment than distributing your portfolio across multiple asset classes to minimise your vulnerability to risks. However, diversification is not a one-time practice. It is a process that demands discipline and an extra effort to learn. You may diversify your portfolio and still earn zero profits. Instead, use diversification as a way of creating a solid balance between your returns and risks. With the right asset class options and market knowledge, you can affordably achieve the benefits of portfolio diversification.

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