Understanding Portfolio Diversification

portfolio-diversification

Understanding Portfolio Diversification

Understanding Portfolio Diversification 2560 1707 AMA Team

Understanding Portfolio Diversification

 If you’re just getting started with investing – or if you’re researching how to get the most out of your investments – then there’s no doubt you’ll have come across the term ‘diversification’ when it comes to building an investment portfolio.

What is portfolio diversification?

In the investing world, portfolio diversification invests in assets across different asset classes, in different companies, sectors, and industries and across different countries to mitigate risk and limit the impact of a poorly performing investment. 

As a result, an investor’s ‘portfolio’ should compromise in various investments. These should be diverse and wide-ranging – though it’s important to note that a diversified investment portfolio doesn’t have to cover every industry or sector – and the positive returns form part of the investment portfolio should counteract the poorly performing investments.

How can investors create a diverse portfolio?

According to mathematical modelling research, a diversified portfolio of 25-30 stocks and equivalent investments provides the most rewarding, low-risk investment method. However, a diversified portfolio can be created with fewer stocks.

Investors should choose several different types of investments to build their investment portfolio, such as:

  • Stocks – shares or equity in a company
  • Bonds – government/corporate issued securities that allow investors to invest in debt.
  • Funds such as…
  • Index funds, which aim to match the performance of a particular index
  • Exchange-Traded Funds (ETFs), which aim to match the performance of a specific index, industry or sector
  • Mutual funds, which aim to outperform an index and are actively managed.
  • Property and real estate
  • Cash equivalents

Moreover, the investments present in the portfolio should correspond to different industries. For example, an investor could have government-issued bonds, different types of funds tracking the tech or healthcare industry, individual stocks in a specific tech or energy company, and more.

To further diversify a portfolio, investors should consider investing in international securities, as they are likely to react differently to market influences than local investments, mitigating the risk of those local securities. For example, tech spending in the U.S. may take a hit one year, while the tech industry in China may continue to thrive.

Why is portfolio diversification beneficial to investors?

By investing in different asset types and across other sectors and countries, an investment portfolio as a whole is subject to less risk, as each asset will respond differently to influences from the market.

So, even when part of the portfolio is exposed to an adverse market influence, this will often be counteracted by other investments which aren’t affected – or are even positively affected – by that particular market influence.

Likewise, this doesn’t just apply to different asset types and different sectors – it can spread across countries. Though a particular market segment may be performing poorly in one country, it may be performing well in another.

This is why international investments play a key, though less thought of, role in portfolio diversification – even if the stocks, bonds or funds are in the same sector as some of an investor’s other investments.

Overall, this means that the amount of risk that your investment portfolio is subject to is minimised, and you’re more likely to receive positive returns – overall – from your investments over a long-term investment horizon.

Are there any downsides to portfolio diversification?

Although portfolio diversification is a staple of the vast majority of investors’ investment strategies, diversification does come with a few drawbacks.

For one, although your risk is significantly decreased – and the likelihood of reaping positive returns from your investments is heightened – you’re also less likely to reap substantial short-term financial rewards from portfolio diversification.

This is in comparison to more ‘high risk, high reward’ strategies, such as investing in a few stocks from companies that you expect to grow inordinately in a short period.

Moreover, to have a truly diversified portfolio, an investor naturally has to have a reasonably large number of different securities within that portfolio, making it more time consuming to manage and often more costly.

This is because, typically, when you buy and sell securities, investors are subject to transaction fees and having a more extensive portfolio can make these add up and put a dent in the profit you earn from your investments.

However, investors can still diversify their portfolios and reduce the time and cost associated with diversification if they purchase investments such as mutual funds, which comprise a diverse range of securities across asset classes, and which can be traded at a lower cost compared to trading individual stocks of all the companies represented by the fund.

So, suppose you want to build an investment portfolio that’s low risk and likely to bring reliable positive returns in the long term. In that case, you should consider implementing diversification into your investment strategy.

AMA Client Testimonials