It is impossible to eliminate all risk factors, but investors have the opportunity to get rid of some of them. So, inexperienced as well as experienced investors should pay more attention to diversification. To cut a long story short, it is a risk management strategy that mixes a wide variety of investments within a portfolio.
Importantly, a diversified portfolio contains a mix of distinct asset types and investments in an attempt at limiting exposure to any single asset or risk. The rationale behind this strategy 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.
According to studies, a well-diversified portfolio of 25 to 30 stocks offers the most cost-effective level of risk reduction.
Diversification tries to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. As a reminder, the benefits of diversification hold only if the securities in the portfolio are not perfectly correlated. They respond differently, in many cases in opposing ways, to market influences.
Investors and fund managers often diversify their investments across asset classes. They determine what percentages of the portfolio to allocate to each class. Interestingly, classes can include stocks, bonds, exchange-traded funds, commodities, and cash and short-term cash-equivalents.
Diversification and investors
Fund managers and investors will then diversify among investments within the assets classes by selecting stocks from various sectors that tend to have low return correlations or by choosing stocks with different market capitalizations.
As a reminder, market capitalization refers to the total dollar market value of a company’s outstanding shares of stock. Notably, market capitalization is calculated by multiplying the total number of a company’s outstanding shares by the current market price of one share. It is worth noting that companies are typically divided according to market capitalization. They divide into large-cap companies with $10 billion or more, or mid-cap companies with from $2 billion to $10 billion. The third category is small-cap, from $300 million to $2 billion.
When it comes to bonds, investors can select from investment-grade corporate bonds, etc.
Advantages and disadvantages of diversification
Investors have the opportunity to diversify their portfolios by investing in foreign securities. For instance, forces depressing the world’s largest economy may not affect Japan’s economy in the same way. Thus, holding Japanese stocks gives an investor a small cushion of protection against losses during an American economic downturn.
Budget constraints and lack of time can make it difficult for noninstitutional investors to create an adequately diversified portfolio. As a result, this challenge is a key reason why mutual funds are so popular with retail investors. More importantly, buying shares in a mutual fund offers an inexpensive way to diversify investments.
Everything has its advantages and disadvantages and diversification is not an exception. Diversification has its share of disadvantages. For example, the more holdings the 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. Besides, diversification’s spreading-out strategy works both ways, lessening the risk and the reward.