Portfolio diversification refers to investment in different securities so that the overall risk is reduced by the mix of investments. Instead of investing in stocks for one company for example, you invest across different sectors. A popular analogy for portfolio diversification is carrying eggs in different baskets. As such, if one basket breaks, eggs in the other baskets are still good.
Importance of Portfolio Diversification
Mitigates unsystematic risk
Ultimately, portfolio diversification limits the exposure to of funds to risk. Specifically, unsystematic risk is eliminated through the use of a portfolio. Unsystematic refers to risk that is specific to a given market segment or company. Thus, if investment is in the specific company and the market events are unfavorable then all your investments are affected.
Portfolio diversification will mitigate the risk if the securities invested in are of negative correlation to each other. This basically means that if security A performs in a specific way in the market then security B should perform in the opposite direction for the risk to be reduced.
Although portfolio diversification does not eliminate systematic risk, which is inherent risk for the market at large, it affects unsystematic risk that be controlled as it is firm specific.
A diversified portfolio consists of investment in different securities in terms of asset classes, markets and across time. Thus, on average, the securities bring forth higher returns in the long term. With an appropriate mix, the portfolio’s performance can be seen as superior.
Takes Care of Market Cycles
You are able to adjust to market cycles smoothy with a diversified portfolio. When the market moves up or down the different mix of assets behave differently. Whether the market is bullish or crashes, you are able to turn the tides into your favor.
Investment in Grown Opportunities for Different Sectors
A diversified portfolio is exposed to the vibrant growth that some of the securities are experiencing. As such, you are able to leverage this and obtain lucrative returns while still investing in other options.
Different Ways One Can Diversify Their Portfolio
There are a number of ways that a portfolio can be diversified.
Diversification across asset classes
This basically entails allocation of portfolio funds across different investment vehicles such as:
- Shares or equity for companies that float their shares to the public.
- Commodities- which are goods that are necessary for production such as cotton and precious metal.
- Bonds – fixed income debt instruments from government or corporates.
- Cash and cash equivalents – that are short term in nature and include treasury bills, money market instruments and certificate of deposit.
- Real estate involves investment in buildings, land and natural resources.
- Exchange Traded Funds that entails investments in securities that are based on an index, sector or commodity.
For this type of diversification, funds are allocated among the different classes or within the same class but with different risk profiles. For instance, investment in shares with a large market capitalization and small market cap entails portfolio diversification. For as long as the investment is in securities with negative correlation, then diversification is achieved.
Diversification Across Markets
This basically involves diversifying across foreign markets. The advantage of this type of diversification stems from the fact that investment in the foreign securities brings about negative correlation with the domestic securities. For instance, investing in securities that are in Japan will have a negative correlation with those in Kenya if there is a major economic event that is affecting Japan’s stock market.
Diversification Based on Time
Investments in securities within a given sector at different times may constitute portfolio diversification. For this, periodic investments where you build your mix of assets based on the amount of funds you have are called for. As such, you purchase less shares when the market goes up and more shares when the market prices are low.
Even though risk is not fundamentally reduced, this investment option looks at purchase of shares without the market being necessarily at peak. The dollar cost strategy works on this principle whereby the market showcases the number of shares you can invest in based on the amount you want to invest in at a particular time.
Diversification Across Industries
This type of diversification involves injection of funds across different industries such as manufacturing, technology, farming and medicine. For this, there is lower correlation of securities with each other and thus risk is minimized. Investment in stocks for companies within the different industries ensures that unsystematic risk is eliminated through the strong performance of stocks from other industries.
Disadvantages of Portfolio Diversification
Investing in different options means that the tax structure varies widely. For instance, tax for debt instruments differ with those from real estate and all this are catered for under the same umbrella.
Given that allocation of funds in different securities is of a specific percentage, then profits gained from a spike are limited to that extent. Investors might feel that this constrains their potential of obtaining complete gains.
Portfolio diversification helps minimize exposure to unsystematic risk to the minimum possible. You are therefore able to earn good returns without being completely submerged due to a major event. Also, you do not need to constantly worry about your securities as they can weather market cycles.