When investing money, it is critical to understand the concept of diversification. Put simply, diversification is a strategy for making portfolios less volatile over time.
Unfortunately, however, the diversification process is anything but simple. A number of different strategies exist depending on the goals of the investor.
In some cases, investors will want to adopt several different strategies to lower the risk involved. It is important to note, however, that lower risk also generally means lower returns. This means that other investors, who are willing to take a riskier approach to achieve higher returns, may implement only a single diversification strategy.
At any rate, it is essential that novice investors become familiar with the different approaches to diversification and why investors might choose each. These approaches include:
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Industry Diversification
When people invest in stocks, they should consider having a balance of different industries represented in their portfolio. Often, individuals begin by investing in the industries they are most familiar with, but it is important to grow away from this strategy over time.
By looking at regional investment trends, patterns become clear. In the West, people tend to invest more heavily in technology companies. In the Northeast, financial companies typically receive the most attention. In the South, energy companies have a great deal of support.
While it is fine to slightly prefer one industry to another, weighting a portfolio heavily toward any one industry puts it at risk if that industry takes a nosedive. For example, if a political event makes energy stocks tank, people invested in that industry stand to lose considerable money – unless they are also invested in other industries.
While everyone will lose money sometimes, diversification curbs potential dramatic drops in the value of portfolios.
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Company Diversification
This principle can be summed up with the adage “Don’t put all of your eggs in one basket.” In addition to investing in different industries, it is important to invest in different companies within that industry.
Company diversification was, surprisingly, not a central principal of investing until the 1950s. That is when Nobel laureate Harry Markowitz demonstrated that adding just one other stock to a single-stock portfolio significantly reduced overall risk – even if the two stocks had the same risk overall.
Some investors choose to leverage company diversification more than industry diversification. They do so by purchasing complementary stocks. Take, for example, someone who is really invested in the energy industry, and who does not want to invest in other industries.
That person can still provide some protection to their portfolio by investing in fossil fuel, solar, and nuclear energy companies. When fossil fuels suffer, people tend to start relying more on the other options, so those stocks will get a boost.
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Geographic Diversification
Most investors, especially in the United States, tend to invest in companies in their home countries. However, there can be significant benefits to diversifying your portfolio to include international stocks.
Through this strategy, individuals can provide some degree of protection to their portfolios should the economy in their home countries begin to wither. At the same time, this type of diversification can be seen as betting against one’s home market, so it does not sit well with all investors.
Proponents of geographic diversification often point to Japan, which had one of the most robust economies in the 1980s, before it suddenly and unpredictably crashed. Geographic diversification protects against this kind of crash.
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Class Diversification
Many portfolios today diversify across different asset classes. Rather than investing entirely in stocks, individuals may also purchase bonds, real estate, commodities, and cash assets.
While it is not necessary to invest in every asset class, the different classes protect against fluctuations in the market. During times of economic recovery, stocks tend to begin performing well. However, bonds offer protection during periods of recession, even if their returns are rather limited.
Similarly, commodities perform well during periods of inflation, while long-term bonds are a great investment during periods of deflation. Also, the real estate and stock markets often balance against one another.
Even within classes, there are different options, such as focusing on small-cap, value, momentum, or high-quality investments. Each of these subclasses has its own advantages and drawbacks.
Predicting which subclass will perform the best in a given year is difficult, if not impossible. As a result, most investors choose to diversify the subclasses they invest in. This means accepting that not all of their investments will be allocated in the current “ideal” subclass. Likewise, however, not all of them will be allocated to the worst strategy.
An Argument against Overdiversification
While there is much discussion about the importance of diversification, it is also possible to overdiversify. The danger of overdiversifying is inhibiting investment gains.
With only a small amount invested in each chosen category, investors will not lose much if one underperforms. However, they will also not gain much if one overperforms.
Part of the philosophy of building a great portfolio is taking calculated risks with asset allocation. While it is important to use diversification to build in some degree of protection, each protection also limits potential for significant gains.