Diversification

What does diversification mean?

Diversification as a market strategy involves spreading investments across various assets, asset classes, industries, sectors, or geographical regions to reduce overall risk.

It refers to the strategy of minimising the impact of a single investment’s poor performance on the overall portfolio, which can potentially increase overall returns by mitigating concentrated losses.

This strategy is built on the principle that putting all your eggs in one basket can lead to significant financial risk.

Benefits of diversifying your portfolio

Diversification is rooted in the concept of risk management and the pursuit of favourable risk-adjusted returns.

These are the key benefits of diversifying your trading portfolio:

Risk reduction

Reducing risk is one of the primary motivations for diversifying your portfolio. It’s all about avoiding the concentrated risk associated with putting all your money into a single investment. Trading a wide range of assets helps to cushion your portfolio from the potential fallout of adverse events affecting a specific company, industry, or asset class. 

Consider a scenario where you have invested all your trading capital on a single company's stock. If that company encounters financial difficulties or faces adverse market conditions, the price may rapidly decline meaning 100% of your portfolio drops in value. Diversification helps to spread this risk, making it less likely that a single negative event will have a catastrophic impact on your portfolio. This is also referred to as hedging, where investing in an asset that rises when the other falters can offset potential losses in one part of your portfolio by creating gains in another. For example, if you’re investing in currencies you might also partially invest in a traditional hedge like gold to balance your portfolio’s risk. However, the effectiveness of gold as a hedge against currencies can vary depending on various factors such as the strength of the currency, global economic conditions, and investor sentiment. It should only be considered as a factor of your diversification strategy, instead of as a guarantee of protecting capital.

Enhanced return potential

Diversification can also increase the return potential of your investment portfolio. This may seem counterintuitive, as one might expect that concentrating investments in high-performing financial assets would yield the best returns. However, it's important to note that different asset classes and investments do not always move in lockstep with one another.

When assets are not perfectly correlated, meaning they do not all respond in the same way to market events, a diversified portfolio can capture opportunities in multiple areas.

While some investments may perform poorly in certain market conditions, others may outperform. By holding a variety of assets, you can balance out the potential losses in one area with gains in another, thus improving your overall risk-adjusted return.

Different types of diversification

Diversification can take various forms, depending on the investment mix and objectives. Some of the most common types include:

Asset allocation diversification

This approach involves diversifying across different asset classes, such as stocks, bonds, cash equivalents, real estate, and commodities.

Each of these asset classes has its own unique risk-return profile, and they may react differently to economic and market conditions. By spreading your investments across these asset classes, you can take advantage of their varying performance patterns.

Stocks may perform well during periods of economic growth for instance, but bonds may do better during economic downturns. A diversified portfolio that includes both stocks and bonds might help balance your exposure to economic fluctuations.

Sector or industry diversification

Within the stock market, diversifying across different industry sectors is a common approach. Various industries, such as technology, healthcare, finance, and energy, may experience different growth rates and volatility. If you were to invest exclusively in one sector, you'd be vulnerable to the specific risks associated with that sector. 

By diversifying across sectors, you reduce the impact of adverse developments in any one industry. For example, if the technology sector experiences a downturn, having investments in healthcare or consumer goods can help mitigate the negative effects on your overall portfolio.

Geographic diversification

Geographic diversification refers to spreading investments across different regions or countries. Economic and market conditions can vary significantly by location, and geopolitical events can impact regional economies. By investing across different regions, you can reduce the risk associated with economic instability in a single area.

For instance, if you hold investments exclusively in the United States and the US economy enters a recession, your portfolio may suffer. However if you also have exposure to international markets that are performing well, you might offset some of these losses. Some popular economies used to hedge against US market risk are the Eurozone, Japan, UK, Switzerland and China - which is what makes the currency market one of the most actively traded financial markets in the world due to it’s large volumes and general volatility.

Security or stock diversification

This form of diversification is about spreading investments across various individual stocks or securities within the same asset class, which can be hedged by investing in an index or ETF that tracks the overall industry’s performance or by investing in stocks from different market sectors. It's especially relevant for stock investors who want to reduce the risk of holding a single stock that could experience significant price fluctuations.

Methods of achieving diversification

To start using diversification, traders and investors can try out various methods depending on their financial goals and risk tolerance:

Mutual funds and exchange-traded funds (ETFs)

Mutual funds and ETFs are popular investment vehicles designed to provide built-in diversification, without requiring individual investors to select and manage a range of individual securities. 

These funds are managed by professional portfolio managers who select the individual assets to be grouped, where the assets are chosen with diversification in mind. Mutual funds are priced once a day after the market closes, while ETFs trade on stock exchanges throughout the trading day. This is a major benefit of investing in ETFs as it means that they can be traded as if they were a single stock, making them a popular choice for individual and institutional investors looking to diversify their portfolios.

Individual stock selection

Experienced investors can create portfolio diversification by carefully selecting stocks from various industries and sectors. They might choose to balance growth stocks with value stocks, or spread risk by investing in both large-cap stocks and small-cap stocks. The key is to make sure their portfolio represents a range of investment opportunities and is not overly concentrated in one area.

For example, they might invest in technology stocks to capture the potential for high growth, but also include utility stocks for stability and dividend income to create multiple sources of return in their diversified equity portfolio.

Bonds

Diversifying within a fixed-income portfolio often involves investing in bonds with different maturities, credit ratings, and issuers.

Government bonds, municipal bonds, corporate bonds, and high-yield bonds have distinct risk profiles. By spreading investments across various types of bonds, an investor can reduce their exposure to interest rate fluctuations and credit risk.

For instance, an investor may hold a mix of short-term US Treasury bonds, long-term corporate bonds, and municipal bonds. In this way, they increase their potential income stability while managing risk.

Real estate

Diversifying within real estate can involve investing in different types of properties, such as residential real estate (apartments and single-family homes), commercial real estate (office buildings and shopping centres), industrial real estate (warehouses and manufacturing facilities), and more. Each type of real estate investment has its own risk and return characteristics, making diversification across property types important.

Investors can also diversify geographically by owning properties in various locations, this is done to mitigate the impact of local economic conditions such as economic inflation or declining house prices. Real estate investment trusts (REITs) are a common way to gain diversified exposure to real estate assets without directly owning and managing properties.

Global investments

To achieve geographic diversification, investors can also opt for international or global funds. These funds combine a variety of assets from different regions and countries, which helps balance exposure to regional economic events and market conditions. Global funds provide a broader spectrum of diversification as they invest worldwide.

By investing in international markets, you can not only spread geographic risk but also gain access to new opportunities and growth areas. For example, emerging market funds can offer exposure to economies with high growth potential.

Risks that can’t be avoided with diversification

It's important to understand that while diversification can significantly reduce unsystematic or specific risks associated with individual investments, it cannot eliminate all risks.

There are market-wide risks that include:

Market risk

This is the risk that stems from broad market movements and events that affect most or even all investments. Factors like economic recessions, interest rate changes, geopolitical crises, and market sentiment can influence any asset within a given market.

Inflation risk

Inflation erodes the purchasing power of money, which affects the real returns on investments. Even a diversified portfolio can be impacted by rising inflation rates.

Currency risk

If you hold investments in foreign markets or assets denominated in foreign currencies, currency exchange rate fluctuations can affect your returns. This volatility creates exciting profit opportunities for investors, but can also carries higher risk.

While diversification cannot eliminate these market-wide risks, it can still provide a cushion against them. The theory behind diversification is that it helps to isolate the unique or idiosyncratic risks of individual investments, leaving investors less exposed to the specific events that can impact one company or one sector.

In summary, the level of diversification in a portfolio should be tailored to your financial objectives and risk tolerance, and it requires periodic rebalancing to maintain the desired allocation.

To maximise the benefits of diversification, it's essential to strike a balance between the number of assets in your portfolio, avoid over-concentration or over-diversification, and consider the correlations between the assets you choose.