What is diversification of investments
What is diversification of investments
Diversification is a risk management strategy that combines a wide range of investments in a portfolio. The point of this method is that a portfolio consisting of different types of assets will, on average, yield higher long-term returns and reduce the risk of each individual investment or security.
Basics of diversification
Diversification tries to smooth out irregular risk events in the portfolio, so the positive results of some investments neutralize the negative performance of others. The advantages of diversification remain only if the securities in the portfolio are not perfectly correlated, i.e. they affect the market in different ways, often in the opposite way
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25-30 shares provides the most cost-effective level of risk reduction. Investing in a greater number of securities creates additional diversification benefits, albeit with significantly lower rates of return.
Diversification by asset class and funds
Fund managers and investors often diversify their investments by asset class and determine what percentage of the portfolio should be allocated to each one. Classes can include:
- Shares of different companies.
- Bonds – government and corporate fixed-income debt instruments.
- Real estate – land, buildings, natural resources, agriculture, animal husbandry, as well as water and mineral deposits.
- Exchange-traded funds (ETFs) are a commodity basket of securities that follow an index, commodity or commodity sector.
- Cash and short-term cash equivalents (CCE) – treasury bills, deposit certificates (CDs), money market funds and other short-term investments with low risk level
They will then diversify their investments within asset classes, for example, by selecting shares from different sectors with a tendency towards low returns or by selecting shares with different market capitalization. In the case of bonds, investors can choose from investment grade corporate bonds, treasury bonds, government and municipal bonds, high yield bonds and others.
Diversification by country
Investors can obtain additional diversification benefits by investing in foreign securities, as they are generally less closely related to domestic securities. For example, the forces that oppress the U.S. economy may not affect the Japanese economy in the same way. Thus, the ownership of Japanese shares gives the investor a small cushion against losses during the American economic downturn.
Diversification for retail investors
Time and budget constraints can make it difficult for non-institutional investors, i.e. individuals, to create an adequately diversified portfolio. This problem is the main reason why unit investment funds are so popular among retail investors. Buying shares in a mutual fund offers an inexpensive way to diversify investments.
While mutual funds provide diversification across asset classes, exchange-traded funds (ETFs) provide investors with access to narrow markets, such as commodities and international trading floors, which would normally be difficult to access. A person with a portfolio of $100,000 can distribute investments between ETFs without overlapping.
Lack of diversification
Reduced risk, volatility buffer: there are many advantages of diversification. However, there are also disadvantages. The more holdings in the portfolio, the more time it takes to manage, and the more expensive as buying and selling a lot of different investments requires more transaction fees and brokerage commissions. More importantly, the diversification strategy works in both directions, reducing both risk and reward
Let’s say you split $120,000 in equal shares between six companies, and the value of one of them doubles, and the rest of them have not changed in price. Your initial bet of $20,000 is now worth $40,000. Of course, you’ve made a lot of money, but not as much as if all that $120,000 had been invested in this company. By protecting you from downturns, diversification limits you, at least in the short term. In the long term, diversified portfolios usually have higher yields.
Intelligent beta versions of investment portfolios
Smart beta strategies offer diversification by monitoring key performance indicators, but do not necessarily weigh shares according to their market capitalization. ETF managers further analyze share problems by key indicators and rebalance portfolios according to an objective analysis, not just the size of the company. Intelligent beta emphasizes the need to consider investment factors or market inefficiencies based on rules and transparency. Smart beta strategies can use alternative weighing schemes such as volatility, liquidity, quality, cost, size and momentum. In 2019, smart beta funds will have total assets of $880 billion
For example, as of March 2019, the ETF’s iShares fund contained 125 U.S. shares with large and medium capitalisation. Focusing on Return on Equity (ROE), debt to equity ratio and not just market capitalisation, ETF has earned 90.49% of its revenue since its inception in July 2013. Similar investments in the S&P 500 index increased by 66.33%.
Example from the real world
For example, an aggressive investor who can take on a higher level of risk wants to build a portfolio consisting of Japanese stocks, Australian bonds and cotton futures. For example, it can buy stakes in the Japanese ETF iShares MSCI Fund, the ETF Australia Government Bond Index and the IPT Bloomberg Cotton Subindex Total Return ETN. Thanks to this combination of ETF shares, due to the special qualities of the target asset classes and the transparency of investments, the investor provides a true diversification of his assets. In addition, with different correlations or reactions to external influences among securities, they can slightly reduce exposure to risk.