Diversification is a technique of spreading investment capital across various types of assets as well as within individual asset classes.
The idea is to limit exposure to any single asset or category, which mitigates risk in the event that one of them experiences a significant loss in value.
How should investors diversify?
An example of diversification in an investment portfolio could be when you own a mix of stocks, bonds, bank certificates of deposits, commodities, and real estate. That gives you a variety of asset classes.
You can diversify further within each asset class. For instance, in the stocks portion of your portfolio, you may buy shares in numerous companies across different industries, countries, market capitalisations, and risk levels.
Why should investors diversify?
As the adage goes: “Don’t put all your eggs in one basket." We do not want to put all our money into a single company or just one type of investment.
No asset class or individual asset has zero risk, and they all come with a risk-return trade-off. In general, the higher the risk, the higher the potential reward or return.
Diversification can minimise the financial loss and volatility when a random or unexpected market event occurs. That protects your savings or retirement funds from being wiped out entirely. The strategy also helps provide consistent returns in the long run.
For example, government bonds carry little risk of default, but may return only about 6% a year on average. On the other hand, stocks, which are typically higher-risk investments, have more volatile price swings but can return 10% a year on average.
To illustrate the importance of diversification, let’s say you made an investment at the end of 2007. If you had bought only stocks, you would have lost half of your investment within a year, by the end of 2008. However, if you had split your capital to invest 50% in stocks and 50% in bonds, you would have lost only a quarter of your investment. Investing in both equities and bonds meant that losses in one asset class were offset by the gains in the other.
How to diversify correctly across portfolios
Asset classes have their own cycles, and some can react very differently from others. When an asset class is generating strong returns, another may be performing poorly.
For example, bond prices tend to move up when stock prices fall. Gold prices usually increase when the US dollar weakens.
Diversification works best when the assets are either uncorrelated or negatively correlated with one another, so that as some parts of the portfolio fall, others are likely to rise. This will offset the volatility of individual investments and spread out your risk.
The ideal scenario is when the price correlation across assets within a portfolio is at or near zero. That means the price movement of one asset will have no effect on the prices of the other assets.
Nobel prize-winning economist Harry Markowitz called diversification "the only free lunch in finance". His theory is that if you hold a portfolio of investments that are not perfectly correlated, an investor can lower risk without sacrificing expected returns.
Simply put, spreading your investments across asset classes and geographies gets you the same reward with less risk. That’s the free lunch.
It is unwise then to have a portfolio of assets with a strong positive correlation. In such cases, the prices of all the assets will always move in the same direction, and therefore there is no hedge against any drop in prices. When the value of one investment declines, the entire portfolio’s value will also plunge.
For the majority of investors, holding a mix of asset classes with a range of correlations to each other — such as stocks, bonds, commodities, and real estate — over the long term can help dampen the overall volatility of a portfolio, without the steep climbs and drastic dips of owning just one asset type.
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