Diversification is an investment strategy focused on risk mitigation. It calls for the creation of a portfolio that contains a wide variety of investments. The logic behind it is that the possible negative yields of some investments are neutralized by the positive yields of other investments in the portfolio.
With the risk of sounding overly simplistic: diversification it not much more than the financial equivalent of “not keeping all your eggs in one basket“.
It has been proven that statistically, diversified portfolios tend to yield better long-term returns. They also significantly reduce risks associated with investments.
Diversification can take shape within an asset class. It can also span multiple asset classes and geographically defined markets.
Although it may limit performance over the short-term, this investment strategy is one of the main tools of institutional investors. Such major players are never in a hurry. Risk mitigation always outweighs short-term gains for them.
They also possess the resources to put together well-diversified and profitable portfolios.
For the retail investor, diversification is obviously more difficult to accomplish. This is one of the reasons why such investors tend to like mutual funds.
Diversification By Asset Or Asset Class
When diversifying across different asset classes, low correlation between the investments is a given. Low correlation does after all favour investment diversity. The choices in this regard are numerous.
- Real estate
- Money market vehicles
- Treasury bills
Diversifying within an asset class is an exercise that requires a touch more finesse. Selecting stocks with low correlation and high profit-potential is what investment professionals do best.
For the rank-and-file retail investor, simply investing in a mutual fund makes more sense.
ETFs offer another reasonable on-ramp to diversified portfolios. While mutual funds offer diversification across asset-classes, ETFs have a narrower scope.
Market capitalization is a factor in this regard as well.
While bonds may seem especially restrictive, there are scores of options there too. There are high-yield bonds, municipal bonds, treasuries, corporate bonds etc.
Diversify Over Geographic Boundaries
Diversifying into foreign markets makes perfect sense. After all, such markets tend to be less correlated with domestic ones, regardless of where the investor resides.
Picking up a selection of US and Japanese stocks, or investing into a US and Japanese index fund is a perfect example in this regard.
Advantages And Disadvantages
Diversification offers risk-management, better long-term returns and hedging against market volatility. Its advantages are fairly obvious. What about the flip-side of the coin though?
Besides the fact that it limits short-term profitability, diversification is also costly. That holds true both money- and time-wise.
Proper diversification entails more commissions and transaction fees. Also, it can be time-consuming to employ this strategy.
As mentioned, mutual funds and ETFs offer retail actors a reasonable shot at diversification.
That said, within the ETF category, there are options which may well outperform the run-of-the-mill ETF.
Some ETF managers have devised equity screening and rebalancing methods based on detailed analysis and fundamentals. This is different from the usual market-cap based approach.
An example in this regard would be ETFs balanced based on debt-to-equity and return on equity ratios.
Some of these ETFs have turned in more than impressive performances.
Diversification is indeed an excellent investment strategy approach. Investors need to consider several factors in its regard however. Risk appetite is one such factor. The specific qualities of the targeted assets/asset classes also matter.
Properly formulated portfolios are difficult to manage and put together. Therefore, ETFs and mutual funds represent the best way for retail investors to diversify.