Most investors are familiar with the phrase "diversification." In the broadest sense, it can be summarized by the statement "don't put all your eggs in one basket." While that statement captures the heart of the problem, it offers little insight into the practical ramifications of diversification in an investor's portfolio. Furthermore, it provides no insight into how a diversified portfolio is constructed. We'll provide you with an overview of diversification in this article, as well as some tips on how to make it work for you.
The idea of diversification is to create a portfolio that includes multiple investments in order to reduce risk.
By effectively diversifying a portfolio within and across asset classes, you may reduce unsystematic risk (avoidable risk), manage systematic risk (unavoidable risk), and eventually develop a more stable and lucrative investment portfolio.
By holding a range of investments in securities within and across different asset classes with little or no correlation, you can reduce exposure to risks that investments share, thereby improving overall portfolio stability and earning potential.
To understand that fully, let’s break down a few key concepts a bit further.
Securities: A security is a passive investment of money in a common enterprise with the expectation of profits (debt, equity, or otherwise). Generally, stocks, bonds, commodities, and other financial instruments that are bought and sold are considered to be securities.
Individual stocks: These are securities that represent partial equity ownership in a public entity, like a corporation. Most investors are familiar with public stocks and the many kinds of stocks available today. Even within the stock market there is potential diversification, between different market capitalization (large cap and small-cap stocks, or emerging markets), and domestic stocks and foreign stocks/international stocks sold through foreign markets.
Fixed income investments: These kinds of securities are debt or debt-like investments that have pre-determined returns for the buyer along a certain timeline. These include securities like bonds sold on a bond market, and can take different forms, depending on the entity of the issuer: treasury bills or government bonds, municipal bonds, corporate bonds, etc.
Market funds: These are vehicles that allow you to buy a broad range of securities contained in a market through the purchase of a single investment vehicle. These can include options like mutual funds, bond indexes, and exchange-traded funds (ETFs).
Asset classes: An asset class is a group of securities that share similar characteristics and behavior. Investments within the same asset class can be prone to the same risks. However, there is a lot of range within an asset class. Asset classes can be broken down further into subclasses, and as classification becomes more specific, levels of similar characteristics and behaviors become more concentrated. Generally, a portfolio with a broader mix of asset classes will have stronger diversification. Taking into account the securities discussed above, major asset classes include:
- Fixed income
- Cash and cash equivalents
- Commodities and real estate
Each of these asset classes can cover many different types of investment sectors, or return profiles, such as capital gains or income.
What are the options?
- Real estate investment through crowdfunding
- Mutual funds
- Equity Investment Choices
Regardless of your means or method, keep in mind that there is no single diversification model that will meet the needs of every investor. Your personal risk tolerance, investment goals, financial means, and level of investment experience all play a huge role in dictating your investment mix.