What Is Diversification?

fortpitt in Investments 1 September, 2021

Diversification is a very important factor that is used to lower the risk inherent in a portfolio. There are many different types of diversification that can be utilized. Each method can be used by itself or alongside the other methods to limit risk and volatility and create more predictable returns. Diversification is a tradeoff. In exchange for steadier returns and a reduction of the effect of picking an underperformer, you give up some of the large performers’ impacts.

What Is Individual Company Diversification?

This method of diversification entails purchasing the individual securities of many different companies. The goal is to limit the impact of any one company’s performance on the overall portfolio value. No one can be certain about the performance of a specific company in the future, and it isn’t easy to pick only winners.

What Is Industry or Sector Diversification?

In sector diversification, you diversify across different industries in the market. The idea is that different sectors perform more strongly in different stages of the economy. Since knowing a country’s economic cycle stage is difficult, you can weigh your portfolio across industries, modifying accordingly to take advantage of sector outperformance.

What Is Asset Class Diversification?

This type of diversification entails holding a multi-asset portfolio composed of stocks, bonds, cash, and other assets. In this case, you are trying to insulate your portfolio during recessions and bear markets with bonds and other “safe” assets while still capitalizing on growth periods where equities and riskier investments are likely to outperform.

What Is Strategy Diversification?

Many different strategies (high-beta, sector rotation, value, etc.) exist in the markets. At any given time, one strategy may be “hot” while the others are a bit lackluster. Mixing up the strategies employed in your portfolio can allow you to always have a piece of the “hot” strategy no matter what that strategy might be.

What Is Geographic Diversification?

It has been shown time and time again that people have a domestic bias when it comes to investing, meaning that they purchase more assets from companies in their own countries. Domestic securities will not always be the best performing. By purchasing assets from around the world, you can gain exposure to different country’s assets that are outperforming at different times.

What Is Time Diversification?

A final option is using dollar-cost averaging. This method entails regular purchases of assets, meaning that you do not invest all at once but gradually over time. Since bad timing or bad luck can have you buying at the highest point in the market, this method seeks to minimize these effects.

Speak to a Financial Professional About Diversification

As you can see, diversification can be realized in a variety of ways. Speaking to a financial professional can help you to determine the best strategy for achieving diversification in your portfolio.

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