One surefire way to become a successful investor is by finding your comfort level with risk against your investing time horizon. Portfolio diversification is one way to help mitigate that risk, but what exactly does it mean?
Let’s dive into what portfolio diversification is, why it’s important and the key components of a diversified portfolio.
What Is Portfolio Diversification?
Portfolio diversification is an investment strategy that works to manage risk while capitalizing on gains. It refers to the practice of spreading your investments around in various types of assets in an effort to cover different bases. Doing so also limits your exposure to any one type of asset, which can help to reduce the volatility of your portfolio over time. Basically: Portfolio diversification is just investment jargon for not putting all your eggs in one basket.
It’s important to note, however, that portfolio diversification does not help to reduce all risk. Systematic or market risk, for example, is unavoidable. Inflation and exchange rates, political instability, interest rates, etc. do not discriminate — these things do not affect a particular company or industry. Therefore, portfolio diversification won’t reduce all risks; some risks investors just have to be willing to accept.
Why Is Portfolio Diversification Important?
Portfolio diversification is important because, by investing in different assets, you balance risk and reward in your portfolio. In short: When some of your holdings inevitably lose money, other investments can help to offset that decline. In fact, several studies have shown that, on average, well-diversified portfolios generate more reliable returns than non-diversified portfolios over a period of 25 years or more.
For example, if you invest too conservatively while you’re young, you run the risk of your investments not keeping up with the pace of inflation. Likewise, if you invest too aggressively when you’re older, you run the risk of it significantly dwindling with market volatility — and you don’t have as much time to recuperate from that loss. By diversifying your portfolio according to your investment time horizon, however, you can theoretically take harder hits because you’ve got money in different places.
You can liken portfolio diversification to stashing cash in various pockets when you travel. If all of your money is in your wallet and your wallet gets pickpocketed, it’s game over. But if you stash some cash in your wallet, some in a hidden pocket of your luggage, some in your toiletry bag and maybe even some rolled up in a pair of socks, you’re still safe if someone snags your wallet. Sure, having your wallet stolen isn’t ideal, but at least you’re prepared to cushion that loss.
Note, however, that portfolio diversification does not guarantee you gains or prevent you from losses. It just helps balance out the potential pros and cons.
How Do You Diversify a Portfolio?
There are different ways to diversify a portfolio, such as by asset class, sector, market capitalization, and correlation. Usually, investors select a mix of alternatives to diversify their portfolio to the fullest extent.
Most of the time, however, investors diversify their portfolios through asset allocation. By mixing up elements of different investment classes in your portfolio — such as domestic and international stocks, bonds, short-term investments (i.e. market funds and short-term certificates of deposit), real estate, gold and other commodities — you can protect your portfolio if one of those perform poorly. If you have both stocks and bonds in your portfolio, for example, your portfolio might not rise as quickly as it would if you had all stocks, but it probably wouldn’t fall as quickly either.
In investing, the main asset classes include:
- Cash and equivalent: Treasury Bills, CDs, money market securities, etc.
- Stocks (equities): Shares purchased from a publicly-traded company
- Bonds: Fixed-income securities (IOUs) ETFs: a “basket” of securities from a specific index, sector, etc.
- Real estate: Buildings, land, water and mineral deposits, agriculture, and livestock
- Commodities: Goods that produce other goods or services
It’s also smart to diversify within those varied asset classes. In other words: Don’t just buy a ton of stock in one sector like the tech industry, for example. Switch it up to maximize your portfolio diversification. Many who subscribe to diversification divide their portfolios by what percentage of their portfolios each asset class will make up first. Depending on which asset classes an investor chooses, they may have more or less ways to split their investments further.
What Are the Downsides to Portfolio Diversification?
With high risks come high rewards, and portfolio diversification helps to reduce risk. An aggressive portfolio with all mostly stocks in a top-performing industry might make you a lot of money. But it also might not. While diversifying your portfolio can help you avoid the latter, it also means that your money might not grow as much as it otherwise would have. Plus, not all assets cost the same, so buying and selling could cost you more when you factor in transaction fees and brokerage charges, too.
Never mind that managing a diversified portfolio can be more time-consuming. Fortunately, that’s why Q.ai is here to help. Q.ai diversifies and manages what we call an investment kit for you, using the power of AI to auto-adjust it with market swings, too.