Introduction
In this case the idea of diversification is the cornerstone of investment that investment gurus and portfolio analysts have prescribed for a long time. The idea involves managing a portfolio of investments with different corresponding risks in such a way that the risks in the portfolio are diversified. The idea is straightforward in other words if one investment is not doing well the rest of the investments can still be stable or increase in value.
The knowledge from this content revolves around the meaning of approaches to advantages of and issues of diversification in investment. It also reveals tangible tips and tricks on how the novice investor and even the most experienced one can apply the principle of diversification to his investment portfolio most successfully. By the end of this paper the following general major conclusions and recommendations to investors willing to develop efficient diversified portfolios will be noted.
Importance of Diversification in Investment
Risk Mitigation
The first and the most well known benefit that investors Associate with their portfolios is the elimination of risk. Every investment is characterised with a certain level of risk because market situation may shift quickly due to the changes in the economic political or other situations.
But again not all investments are affected by these changes in the same manner as seen below. For instance the stock of technology companies may reduce in value because of changing regulations on infrastructure development on the other hand gold may appreciate because traditionally it is used as a safe haven asset during periods of uncertainty.
Diversification helps eliminate the risk of loss since investments are made in different classes businesses and geographical locations. This way they are protected against the possibility of having most of their investments on one particular asset. Therefore although diversification cannot eradicate risk comprehensively it provides an effective way through which the aptitude of a catastrophic loss is minimised comprehensively.
Smoothing Returns
This may result in either a gain or loss of value within an investors portfolio due to movement within the market. That way even though some may go up more than others or down less the general pattern evens up. Diversification means that the portfolio will include many different types of investments so the return will be even compared with a focused portfolio which includes many shares of a single company or group of companies.
A diversified portfolio consists of high risk investments and low risk investments thus achieving high returns with minimum risk over the long term investment. For instance in a particular period equities may be Lower than expected. At the same time bonds or real estate may provide steady returns thus decreasing the effect of poor equity performance on the portfolios result.
Exposure to Growth Opportunities
Diversifying not only brings in lower risks but also an opportunity for better yields. In other words an investor can invest in several sectors and markets and each of them may hold potential for growth. Investments made in other countries for instance can open the markets with possible higher growth rates than the domestic ones can offer.
In addition diversification across sectors will be useful to investors since growth trends can be found in different parts of the economy. Thus such investment opportunities as green energy may generate better results compared to more traditional oil and gas stocks as the world increasingly moves toward sustainable development. In contrast technology stocks may maintain their high growth rates thanks to technological progress.
Types of Diversification
Techniques of diversification can be illustrated in the following ways. The following are the common types of diversification strategies available to investors to minimise risks while maximising returns.
Asset Class Diversification
Investors can diversify their portfolios by spreading investments across different asset classes such as Investors can diversify their portfolios by spreading investments across different asset classes such as
Stocks
Equities refer to shares in a company and these are known to offer high returns though the risks associated with them include market risks.
Bonds
These are bonds which are debt securities that pay a relatively predictable and comparatively low rate compared to equities. Bonds are relatively less risky tools and they are basically employed to offset risk in a portfolio.
Real Estate
Housing investment deals are income producing due to rent and gains that are released from the appreciation of the property. They also have low sensitivity to stock or bond market fluctuations and can therefore be used to spread the risk.
Commodities
Metals including gold and energy such as oil and food items are valuable since such assets can help protect against inflation and offer a change from investments that are more closely tied to the financial markets.
Cash Equivalents
These consist of money market funds and certificates of deposit or CDs which are safe and very liquid with very low rates of returns.
Sector Diversification
Another way of diversifying is to invest in sectors that are different from one another. The various aspects of the economy work in diverse ways depending on some factors such as technological innovations consumer tastes or governmental policies. This means that through diversification across organisations of different sectors investors can minimise being subject to a lot of risk from one particular sector. For example an investor can allocate funds across sectors such as
Technology
Healthcare
Finance
Energy
Consumer Goods
This makes markets attractive for investors because if one sector is depressed then the profits that have been invested in it can be balanced out with the profits from other sectors that are more buoyant.
Geographic Diversification
Geographic diversification is a situation whereby investments extend to different countries or regions. The international markets could be more perfectly synchronised thus it is possible to experience poor performance while others are good. Economic political and currency risks are also different from one area to another therefore regional diversification is among the most effective strategies for reducing portfolio risk.
For instance the US stocks may decline due to some factors existing in the US economy while stocks in Asia or Europe may do well. Diversification involves investing money in several areas of the world so that when there are poor returns in a given region other regions with good returns will balance the poor returns.
Time Diversification (Dollar Cost Averaging)
Another type of diversification entails the act of completing investment purchases gradually and not in one go as is usually the practice. This we call dollar cost averaging. Due to this investors are able to invest the fixed amount at predefined intervals which will also minimize fluctuations in the market price. This means that when prices are high the fixed amount of money buys a lesser number of shares while at low prices it buys a bigger proportion of shares.
In the long run this approach can prove to be quite effective in bearing average costs per share and also minimise the risk of market timing.
How to Invest for Beginners?
Portfolio diversification is a stepwise process of the distribution of investment assets analysis and restructuring. The following are lessons that investors can practise to increase the diversification of their portfolios.
Determine Your Risk Tolerance
The first step in all portfolios is to determine the risk profile of the investment based on the abilities and restrictions that the investors have. Risk Taking capacity is the measure of one’s capacity and preparedness to bear a loss in the investment portfolios. This depends on the individuals age the financial targets to be met income earned and investment knowledge among others.
For a young investor this is because they can afford to invest in industries that are most volatile and have more time to wait for a market correction but someone in their retirement years needs to preserve their wealth and get regular income. Using risk tolerance you are able to identify resources that are ideal depending on the amount of risk that an individual is willing to take.
Asset Allocation
After assessing your risk taker ability you now have to decide on the proportion or percentage of your portfolio investment to put into one or more classes of assets. This is called asset allocation and it is one of the key factors in the return on your investments in the long run. The strategic management of investment in different classes of security for diversification is to achieve the optimum risk/reward ratio.
For instance a bearish investor may invest a relatively large amount in money markets and bonds compared to a bullish investor who would invest considerably in stock real estate or gold among others.
Choose Investments
The next phase of portfolio management is the selection of an appropriate investment for each class of asset. This means looking at particular equities fixed income instruments common funds exchange traded funds and other investment kinds. When selecting investments consider factors such as When selecting investments consider factors such as
Performance History
Investment management team (For all mutual Funds and ETFs)
Expense ratios
Dividend yields
Growth potential
Rebalance Regularly
The content of the market evolves over time resulting in a change in the value of the different investments. Consequently it is vulnerable to having a portfolio’s allocation of assets deviate from the target allocation. In order to keep the diversification going it is important to make some adjustments to one’s portfolio at some point in time. Asset rebalancing means selling some of the stocks that were earlier performing better than expected and purchasing more of the stocks that are not performing up to expectation while aiming at getting to the initial set asset allocation.
For instance if your target investment is 60% stocks and 40% bonds but because of the stock appreciation you find that you have 70% of stocks and only 30% bonds you will now sell off some of the stock and buy bonds to get back to your ideal proportions.
Stay Informed and Adapt
Markets are constantly in a state of flux and thus factors like the economic environment interest rate fluctuations inflation and other geopolitical events do impact investors. To be a good portfolio manager you must be aware of the global and sectoral factors at large. Also your financial circumstances and objectives can alter during your investment hence there is a need to review the investment strategy from time to time.
Diversification Utilising Mutual Funds
These include mutual funds and exchange traded funds (ETFs) which are other common types of investors that may further assist investors in diversifying their portfolios. Mutual funds and ETFs are two ways in which many individuals contribute their money and the money is invested in a large basket of securities to minimise risk.
Mutual Funds
This is an investment pool that is managed by professional fund managers who invest pooled money belonging to several investors in securities like shares bonds etc. An important point associated with mutual funds is the fact that they provide widespread diversification for portfolios which are only directly available to individual investors who wish to invest their money and effort in the selection of individual stocks and even bonds. Mutual funds come in various types including
Stock Mutual Funds
They participate in stocks that have the possibility of being brought for sale at a higher price.
Bond Mutual Funds
In the structure the emphasis is made on bonds that guarantee a stable income and capital preservation.
Balanced Mutual Funds
Take an equal quantity of stocks and bonds for moderate risk and return.
Exchange Traded funds (ETFs)
Like mutual funds ETFs combine money to purchase a portfolio of securities and shares of ETFs trade on a stock exchange. Nonetheless they are purchased similarly to individual stocks in a stock exchange making them more flexible as compared to mutual funds. ETFs are commonly cheaper because the expense ratios of these investment funds are usually comparatively smaller. In addition they are very flexible where for instance one can purchase shares and then sell them during trading hours.
Challenges of Diversification
Though diversification has lots of advantages the strategy is full of complications. Some common obstacles include
Over Diversification
The greatest mistake that one can make in investment is to invest in too many investment avenues so that returns get watered down. Over diversification happens when the investor has invested in too many securities so the portfolio earnings potential is constrained and the management process is complicated. The objective of diversification is to minimize risk but at the same time you want to get as much upside as the market offers. When you diversify too much you get a portfolio that in effect replicates the markets returns.
Costs and Fees
In diversification transaction costs management fees and other related expenses increase the overall costs of investment. Mutual and ETFs have certain fees known as expense ratios which may differ greatly. Also trading in single shares of stocks or bonds may attract some charges like those of a broker. These costs should therefore be taken into account by investors so as to manage the risks of diversification effectively.
Lack of Control
In the case of a mutual fund or ETF investment investors have relatively limited control over the contents of the portfolio. Fund managers are the ones who decide which assets to purchase and which to sell and investors may sometimes disagree with such decisions. This can be not very pleasant especially for individuals who love to monitor their investments very closely.
Therefore the correlation impact on diversification found within the different industries has received considerable consideration in the literature.
Another feature that explains the success of the diversification strategy lies in correlation. Correlation indicates the degree of the fluctuation of returns between two investment assets. The measure often called the correlation coefficient varies between 1 and 1 as follows
Perfect positive correlation (+1)
Increase and decrease correlation two assets vary in tandem and go through movements in the same direction.
Perfect negative correlation (1)
It can be stated that two assets are inversely related to each other.
No correlation (0)
One is totally independent of the other. It does not have any connection with the movement of another. Two is independent of one. Another crucial thing to put into consideration is the need to diversify through the assets that one invests in which should not have a direct correlation. It simply means diversification will not eliminate risk if all the assets in a portfolio have a similar direction of movement.
The reason for this is that ideally a portfolio should be chosen in such a way that returns on different projects do not move in line with each other but should have low or no correlation.
Global Events in Relation to Diversification
The events that unfolded in the global market in the last year including the COVID19 pandemic strained global relations and disrupted supply chains are good examples of how the strategy of diversification helps mitigate risks. At the height of the COVID19 pandemic there was a lot of fluctuation in the global markets though there were pockets of strength like technology stocks and gold among others.
Like in the case of the coronavirus disruptions supply chain disruption had a negative impact in some industries albeit a positive one in industries such as digital services. Also regional relationships such as trade wars or conflicts can affect investments in specific regions or fields. The risks of investment are high in geographic concentration and geographic diversification minimise these risks.
Conclusion
Measures such as diversification are crucial as they provide many advantages such as reducing risks involved maintaining steady returns and promoting potential growth investments. Due to diversification investors can create portfolios of efficient structures to withstand fluctuations in the market and economic crises.
However there are always diverse difficulties associated with the diversification process. A few inconveniences that investors have to focus on include the ease of diversification which can lead to overdiversification leading to increased costs or lack of control. Moreover diversification means that the correlations between different assets have to be taken into consideration so that one must select the appropriate instruments.
There is also a need for investors to keep updated with global trends and economics and more so personal financial goals so as to achieve portfolio objectives. So with a good diversified portfolio one can earn good returns and the fluctuations in the market dont necessarily have to be harmful.