What is diversification?

Understanding diversification 

A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will on average yield higher long-term returns and lower the risk of any individual holding or security.

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralises the negative performance of others.

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralises the negative performance of others.

Diversification strategies 

As investors consider ways to diversify their holdings, there are dozens of strategies to implement. Many of the strategies below can be combined to enhance the level of diversification within a single portfolio.

Asset Classes 

Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Each asset class has a different, unique set of risks and opportunities. Classes can include:

• Stocks — shares or equity in a publicly traded company

• Bonds — government and corporate fixed-income debt instruments

• Real estate — land, buildings, natural resources, agriculture, livestock, and water and mineral deposits

• Exchange-traded funds (ETFs) — a marketable basket of securities that follow an index, commodity, or sector

• Commodities — basic goods necessary for the production of other products or services

• Cash and short-term cash-equivalents (CCE) — Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments

The theory holds that what may negatively impact one asset class may be beneficial to another. For example, rising interest rates usually negatively impacts bond prices as yield must increase to make fixed income securities more attractive. 

Industries and sectors 

There are big differences in the way different industries or sectors operate. As investors diversify across different industries, they become less likely to be impacted by sector-specific risk. Investors can diversify across industries by coupling investments that may counterbalance different businesses. 

There are big differences in the way different industries or sectors operate; as investors diversify across different industries, they become less likely to be impacted by sector-specific risk.

For example, consider two major means of entertainment: travel and digital streaming. Investors hoping to hedge against the risk of future major pandemic impacts may invest in digital streaming platforms (i.e. positively impacted by shutdowns). At the same time, investors may consider simultaneously investing in airlines (positively impacted by less shutdowns). In theory, these two unrelated industries may minimise overall portfolio risk.

Diversification and the retail investor 

Time and budget constraints can make it difficult for individual investors to create an adequately diversified portfolio. This challenge is a key reason why mutual funds are so popular with retail investors. Buying shares in a mutual fund offers an inexpensive way to diversify investments.

While mutual funds provide diversification across various asset classes, exchange-traded funds (ETFs) afford investor access to narrow markets such as commodities and international plays that would ordinarily be difficult to access. This is advantageous to investors because it may be costly to individually buy securities using different market orders.

Pros and cons of diversification 

The primary purpose of diversification is to mitigate risk. By spreading your investment across different asset classes, industries, or maturities, you are less likely to experience market shocks that impact every single one of your investments the same. There are other benefits to be had as well. Some investors may find diversification makes investing more fun as it encourages exploring different unique investments. 

Some investors may find diversification makes investing more fun as it encourages exploring different unique investments.

The drawback to diversification is that the more holdings a portfolio has, the more time-consuming it can be to manage — and the more expensive, since buying and selling many different holdings incurs more transaction fees and brokerage commissions. 

Pros of diversification

• Reduces portfolio risk

• Hedges against market volatility

• Offers potentially higher returns long-term

• May be more enjoyable for investors to research new investments

Cons of diversification

• Limits gains short-term

• Time-consuming to manage

• Incurs more transaction fees, commissions

• May be overwhelming for newer, inexperienced investors

Key Takeaways

• Diversification is a strategy that mixes a wide variety of investments within a portfolio in an attempt to reduce portfolio risk.

• Diversification is most often done by investing in different asset classes such as stocks, bonds, real estate, or cryptocurrency.

• Diversification can also be achieved by buying investments in different countries, industries, sizes of companies, or term lengths for income-generating investments.

• Diversification is most often measured by analysing the correlation coefficient of pairs of assets.

• Investors can diversify on their own by investing in select investments or can hold diversified funds that diversify on their own.

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