Originally published on Zinvest: zvstus.com/blog/what-is-a-diversified-portfolio
Diversification Defined:
Diversification is a strategy that mixes a collection of investments within a portfolio. This practice focuses on asset allocation and spreading investments across a range of different securities to limit volatility and risk.
Introduction
The general idea of a diversified portfolio isn’t to maximize profits but for investors to lessen their risk and volatility by investing in multiple assets.
A diversified portfolio can consist of different types of asset classes, typically arranging stocks, bonds, and other securities into the mix.
Assets in a well-diversified portfolio have minimal connection with each other, so in the event of an economic decline, reactions will differ. If the value of one asset were to fall because of a market crash, it does not mean the rest of your portfolio falls too; instead, the value of another may rise, balancing out your losses.
Why Should You Diversify Your Portfolio?
If a shareholder bet all their funds into one stock, they’re gambling their investments on the chance the company’s stock succeeds in the short term — and sometimes, it might work.
So… why should you build a diversified portfolio?
Realistically, it’s a large wager putting “all your eggs into one basket,” because if the company were to crash or financially decline, so does the investor’s profits and investments.
Diversification essentially spreads the risk of investments over different assets and points in time. When you’re assembling a well-rounded and diverse collection of securities, you’re balancing out your potential losses with your benefits by understanding the risk tolerance.
For example, if there were high market volatility, and a stock you owned from Company A began to perform poorly, your previous investment with Company B might be able to limit your losses.
The main tradeoff from having a diversified portfolio is its potential returns. Typically, a diversified portfolio will fetch lower earnings overall than if you were to invest heavily in one successful asset.
However, investing in just one asset carries greater risk if the security performs poorly. Essentially, when you diversify your portfolio with different investments, you’re lowering that higher risk.
What a Diversified Portfolio Should Consist of
There are multiple components towards building a diversified portfolio, depending on the preferences of the investor. Each option has its risks and rewards, but as mentioned prior, a diverse group of investments provides portfolio stability.
Here are some asset classes to include when you build a diversified portfolio:
1) Common/Domestic Stocks
Common stocks offer the most growth for long-term traders and usually make up the bulk of an investment portfolio.
Depending on economic conditions, different sized businesses (small-cap, mid-cap, large-cap) will respond differently — investors should consider a mixture of these stocks.4
To learn more about the different business sizes, check out our article on market capitalization.
2) Bonds
Bonds are fixed-income investments that provide lower returns than stocks in the long term but are a less volatile and safer option overall.
As an example, if there is high market volatility, an index may decline. When prices begin to fall, investors might panic sell and opt for lower-risk investment options. The saying “when stocks go down, bonds go up” holds, as fixed-income securities thrive when the stock market declines.
3) International/Foreign Stocks
Investing in foreign stocks alone can be extremely risky; diversification helps limit the high risk if investments were to perform poorly.
A portfolio’s diversification can be increased with the addition of international stocks. These stocks have different regulations and opportunities that U.S. securities may not offer but at the cost of being a high-risk, high-reward investment.
Exchange-traded funds (ETFs) and index funds provide different ways to invest in foreign stocks as both options offer international market exposure with a basket of securities within an index.
4) Mutual Funds
Mutual or index funds, such as asset allocation funds, are groups of securities in different asset classes (such as stocks and bonds).
You can also invest in exchange-traded funds (ETFs), real estate investment trusts (REITs), and other commodities to help diversify your portfolio.
Fund managers purchase and handle the assets within a mutual fund, and then investors receive the diversified collection of securities. Essentially, investing in these funds is safer than individual investments, as the funds are professionally managed and allocated to benefit the trader.
Keep in mind that mutual funds should not replace a strategized investment portfolio — they only offer small portions of shares from different companies.
Other Considerations (Alternative Investments)
From real estate funds to cryptocurrency, there are a variety of other options to consider when diversifying portfolios. These alternatives let investors focus on rounding out their portfolios with less common assets.
For example, diversifying your portfolio with real estate funds can help against inflation risks while investing in sector funds offer opportunities in particular segments of an economy.
For increased stability, a diversified portfolio should include other short-term options, such as money market funds, short-term cash equivalents (CCE), and certificates of deposit (CD).
Drawbacks to Diversification
An investor trying to diversify their portfolio means they’re taking the right step in investing smartly. Diversification offers many benefits with the key takeaways being risk tolerance and portfolio stability.
However, as is with all investing, there are also a few drawbacks to portfolio diversification. Some of these disadvantages include:
Higher fees — Investing in a large collection of assets can become expensive when constantly buying and selling stocks. Transaction fees and brokerage commission can pile up in the long term, and those investing in asset allocation funds will also have to pay fund managers.
Lesser returns — As mentioned previously, diversification means you’ll be investing in multiple assets to spread the risk. This can result in lower profits as there’s a high chance not all assets succeed.
Extremely time-consuming — The more assets an investor has in their portfolio, the more time they have to spend managing it, and handling a bundle of different securities can be time-consuming. External factors can add to the time consumption as well. As an example, investing during a bear market where prices are constantly fluctuating.
Conclusion: Should You Balance Your Portfolio Risk?
A diversified portfolio is an investor’s best tool to combat risk and volatility; constructing a well-thought-out diversification strategy can pay dividends for long-term investors.
Although lower returns might not sound favorable to some, reducing the impact of unpredictable market trends is beneficial to overall portfolio success.
