Diversification: Balancing Risk and Return
Diversification is an investment strategy where an investor spreads out their money between multiple different investments so they do not leave too much money invested in a single investment. This can help mitigate some risk to your investments if something happens to one of them, whereas if you invest in fewer things, you will lose more if one of those investments crashes. Diversification will reduce your risks without costing your returns. In this article, we will cover how diversification works and how to diversify your investment portfolio.
What is diversification?
Diversification is a commonly used investment strategy where you spread your investments across several different types of investments and asset classes to help mitigate the risks of market volatility. When you diversify your portfolio, you blend several assets that are not similar, so there is not too much exposure to only one sector or asset class. There are many market sectors and asset classes, each of which comes with pros and cons.
Diversification by Asset Class
In investment stock portfolios, there are three main asset classes: cash, stocks, and bonds. There are also other asset classes that have a lower correlation to the stock market, so they can be a great tool to use in diversification.
Diversification with Stocks
Stocks allow an investor to own part of a company. They have some of the highest long-term gains, but the stock market is known for its volatility, so it can be risky to invest too much into stocks.
When investing in stocks, there are a few ways you can go about keeping it diverse. You can invest by industry or sector, which can help mitigate some of the risks to investments. You can also choose to invest by the size of companies or the market capitalizations.
Diversification with Bonds
When investing in bonds, you are loaning money to either the government or a large company, and your gains are the interest on the loan when it is paid at the time it matures. Bonds can help generate an income, but the returns are pretty modest.
You can diversify your portfolio with bonds by getting bonds from multiple types of issuers, such as bonds from the government and different corporations. You can also select bonds based on the level of creditworthiness of the issuer, which can help give you some safety in your return from the bond. The other way to diversify bonds is by blending together different bond terms. A long-term bond gives a higher return because it is riskier but having a few short and intermediate-term bonds is also a good idea.
Other Investment Options
You can also have cash to give you a buffer against volatility. Investing in other physical assets is also a good idea to help with the diversification of your portfolio.
Why is diversification important?
Diversification reduces the overall risk to your investments and increases the potential for your overall returns; many call this a "free lunch." Some assets may do poorly this year but excel next year, and vice versa, which is why diversification matters. You do not want to be stuck in a year where your only investments are doing poorly because you did not diversify your portfolio enough. If, for example, one of the companies you have bought stocks in goes bankrupt, if you have enough investments in other sources and asset classes, you can absorb that loss of that investment with little to no real impact on you. Diversification is important because it offers you peace of mind.
How Diversification Benefits You
As an investor, diversification comes with several benefits, but the biggest is that it has the potential to stabilize your returns, if not improve them. Owning several assets that all perform differently means that a single investment failing will not hurt you as much. This is why it is highly encouraged for any investor to diversify their portfolios.
It is important to keep in mind that diversification can help protect you from some risks, but it cannot eliminate every risk. If the stock market crashes, you will still feel some risk, though your investments in
How to Build a Diversified Investment Portfolio
It can be complex to put together a diversification strategy, especially if you do not have the experience, skills, or time required to research every individual investment to determine if it is worthwhile for you. A passive investor often invests in an exchange-traded fund or a mutual fund on the S&P 500 index, which is a diverse stock index with 500 large companies in it. It has a diverse range of companies you can invest in, but these investments are full of stocks, so you will not be fully diverse if you stick with just these.
For example, in a basic diversified investment portfolio, the investor puts 75 percent into the S&P 500 index and 25 percent in diversified bond funds. A more complex diversification has an investor putting money into S&P 500 index, diversified bond funds, developing markets funds, and both small-cap and mid-cap funds. In doing so, you provide more to cushion them. You can then invest in real estate to diversify your portfolio even more.
Balancing Risk and Return
Diversification helps protect you from loss, but it can cost you in your annual returns because risk and reward are linked in the investment world. Without risk, you will be reducing your returns. It can be difficult to determine how to diversify your portfolio enough to protect you from risk while still giving you a great return on your investments. The best way to go about diversification is by doing what makes you feel comfortable.
Bottom Line
Diversification is a simple way for you to continue to receive returns while cushioning you from some of the risks with other investments. With diversification, you are not keeping all of your eggs in one basket; you are spreading them out. There are many benefits to diversifying your investment portfolio, and you can yield excellent rewards from it.