Being limited by only one or two kinds of assets is risky for an investor’s trading portfolio. Diversification is one of the common strategies to protect a portfolio from risks. It is one of the cornerstones of the Modern Portfolio Theory, developed in 1952 by Harry Markowitz. According to this theory, it is possible to build an "efficient frontier" of optimal portfolios that offer the maximum expected return for a given level of risk.
What Is Diversification?
It is a risk management strategy aimed at including different (diverse) kinds of assets in the portfolio. As a result, the positive performance of one kind of assets can suppress the negative performance of other assets. In other words, the more assets you have, the fewer investment risks you will encounter. According to studies, the optimal number of securities in an investment portfolio for the most cost-effective risk reduction is between 25 and 30.
In general, there are two types of diversification – by asset class and by investing not only in domestic but also in foreign markets.
Diversification by Asset Class
You can diversify your portfolio by the following asset classes:
- Bonds: Debt instruments of corporate fixed income and government.
- Cash and short-term cash equivalents (CCE): Certificate of deposit, money market vehicles, treasury bills, and other low-risk, short-term investments.
- Commodities: Basic goods necessary for the manufacturing of other products or services, such as crude oil, gold, or agricultural goods.
- Exchange traded funds (ETFs): A marketable basket of securities that follow an index, commodity, or industry.
- Real estate: Buildings, land, natural resources, etc.
- Stocks: Equity or shares in a publicly traded company.
Diversification by Foreign Markets
Investors can further benefit from diversification by investing in foreign assets because they are less correlated with the domestic ones. For example, factors that impact the US economy may not affect the economy of other countries, e.g. China, in the same way. Therefore, holding Chinese stocks protects an investor against losses in case of an economic decline in the United States.
Optimal Diversification Strategies
To make sure that your portfolio is as diverse as possible, consider the following strategies:
- Split it among several asset classes.
- Choose the investments with various risk levels, to ensure that large losses are neutralized by gains in other areas.
- Vary your securities according to industry, to decrease the impact of industry-specific risks.
Drawbacks of Diversification
An undeniable advantage of a diverse portfolio is the reduced risk. However, it also has a range of disadvantages, such as:
- Suitable only for long-term investments. Diversification offers higher returns only for long-term investments. When it comes to short term ones, there are certain limitations. For example, if you have invested $100,000 equally among 5 securities, and one of them doubles in value, your original $20,000 stake is now worth $40,000. This gain is less than by investing the entire sum in that one security the value of which has doubled.
- Time-consuming. The more assets you have in your portfolio, the more time you need to manage all of them.
- More commissions. Buying and selling various assets results in a large number of transactions, thus leading to more transaction fees and higher brokerage commissions.
Diversification is a good way to secure an investment portfolio against risks. It is possible to diversify the portfolio both by asset class, e.g, bonds, cash, stocks, etc. and by foreign markets, i.e. through investments in assets of other countries. However, this strategy works only for long-term investments and can be time-consuming and expensive due to a large number of assets, transactions, and related commissions.