Portfolio diversification is one of many investment strategies that is often talked about, but yet remains grossly misunderstood. Remarkably, the misunderstanding is there even among experienced investors. Although diversification is broadly known to be a way to avoid investment risk and optimize returns, it is often poorly executed.
There’s a belief that if one holds a basket of stocks, say, ten different tickers, they have a well-diversified portfolio. That's not the case. Similarly, holding a variety of stocks in different industries is not always a enough to say the portfolio meets the criteria for strategic diversification. Most recently, the rise of cryptocurrencies have muddied the waters even more, with some investors believing that exposing half of the portfolio towards crypto is sufficient for diversification.
While some of these strategies might serve a s good start for portfolio diversification, they fall short of the definition of a well-diversified portfolio. Let's take a look at what a good portfolio diversification approach should be by first defining what it is: Diversification is a investment strategy where we attempt to allocate investment a variety of financial instruments, industries, and other categories. One of the main goals of diversification is to reduce investment risk by minimizing losses.
To execute diversification correctly often requires also investing in different geographic regions that would each react differently to the same event. In essence, diversification can protect investors from massive losses during market volatility.
Don’t put all of your eggs in one basket
Understanding the importance of investment diversification comes down to the old adage of not putting all of your eggs in one basket. If you drop your basket, all of yours eggs are likely to break. If you set the basket down and leave it by itself, the eggs could be stolen by some predatory animal, or a tractor could accidentally run over the basket. In some cases, it’s best to have multiple baskets that are placed in different locations or even different farmhouses, that contain more than just eggs. I think that's enough farm analogies for now, but you get the point.
With that in mind, the goal is to create a portfolio that includes a mix of investments that behave differently under different market conditions. Diversification recognizes that different assets have varying levels of risk and return potential, and by combining them, investors can achieve a balanced and resilient investment portfolio.
How does diversification work?
Diversification works to help reduce and/or manage risk by spreading investments across different asset classes. Allocating investments across different asset classes, such as stocks, bonds, real estate, and commodities, is the foundation of diversification. Your risk tolerance, financial goals, and time horizon should be factored into how the portfolio is constructed. Geographical diversification is another component that involves investing in different regions and countries.
Investing in different regions and countries helps investors access global opportunities and reduces the risk often associated with concentrating investments in a single country or region. Here too, this is an example of not putting all of your eggs in one basket, or in this case, not focusing on just one country. All of this creates the framework for diversification and helps ensure a well-balanced portfolio.
Under this framework, when one asset class experiences a downturn, others may perform well, cushioning the impact on your overall portfolio. By diversifying, investors reduce the likelihood of catastrophic losses and limit exposure to any single investment or sector. Diversification also brings more stability to the portfolio by reducing volatility. For example, as some investments decline, others may remain steady. Better yet, they may even increase in value.
Key Takeaway
Investment diversification is a powerful strategy that can help investors manage risk, stabilize portfolios, and maximize returns. By spreading investments across different asset classes, regions, industries, and even investment vehicles, investors can reduce the impact of individual investments' performance and withstand market volatility.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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Richard Saintvilus
After having spent 20 years in the IT industry serving in various roles from system administration to network engineer, Richard Saintvilus became a finance writer, covering the investor's view on the premise that everyone deserves a level playing field. His background as an engineer with strong analytical skills helps him provide actionable insights to investors. Saintvilus is a Warren Buffett disciple who bases his investment decisions on the quality of a company's management, its growth prospects, return on equity and other metrics, including price-to-earnings ratios. He employs conservative strategies to increase capital, while keeping a watchful eye on macro-economic events to mitigate downside risk. Saintvilus' work has been featured on CNBC, Yahoo! Finance, MSN Money, Forbes, Motley Fool and numerous other outlets. You can follow him on Twitter at @Richard_STv.
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