6 main benefits of diversification in investing
To diversify or not to diversify…The short answer is yes, but you probably want to know why.
Before you read on, here is an interesting fact: people ask more “why” questions after failure than after success, as shown by a study. So, if you’re already wondering why diversification is important—before the lack of it made you lose funds—you’re one step ahead.
Getting back to the subject, here are 6 reasons for diversification as well as a few examples of well-balanced portfolios.
1. Lowers portfolio risk
The reason for diversification is the reduction of portfolio risk without having to sacrifice the potential returns. At least, that’s the primary reason why most investors are doing it.
If you diversify well, your portfolio will be spread across different assets, countries, and sectors, preserving your capital and increasing your risk-adjusted returns. While it doesn’t eliminate the risk completely, the phrase “Don’t put all of your eggs in one basket” has been around longer than financial markets— and it works.
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2. Reduces dependence on a single asset class
Different types of investments don’t perform well simultaneously. When one asset class is down, diversification allows you to recoup your losses from another asset class. Although, it’s important that some of your investments move in a negative correlation.
For example, it wouldn’t be wise to hold your funds in commodities exclusively. If there is a supply chain disruption or a political turmoil in the production country, it could plummet your entire portfolio.
3. Increases exposure
Because you’re not attached to a single form of investment, you are free to explore other markets. And more exposure means more opportunities. For instance, you can increase your chance of exposure to investments that are leaders in their sectors or markets. At the same time, you increase your chances of finding an upcoming gem that is about to blow up.
4. Hedges against market volatility
Making diversified investments is the most effective form of hedging. Among investors, it’s more popular than opening opposite positions, shorting, fencing, holding cash, and any other risk mitigation technique.
Sometimes, the best-performing asset class one year becomes the poorest performer the next year and vice versa. For example, emerging markets equity and bonds. But if you look at the percentage of change, a year of positive returns can mean different things. While bonds rarely become the highest-yielding class, it hedges against the times when emerging markets are down.
5. Ensures adequate liquidity
Liquid investments, those that can be readily converted into cash, are great additions to any portfolio. These assets hold adequate demand from buyers and sellers, and they allow you to quickly enter and exit positions involving them.
But diversification is part of liquidity, too. Analysts found that diversification is a major factor of portfolio liquidity and is even more impactful than balance and size. Interestingly, investment funds holding less liquid assets tend to diversify more.
6. Provides freedom from timing the market
The last on this list of advantages of diversification is the freedom it gives. Some investors spend a lot of time and effort trying to identify the best moment to enter the market and when to get out. This would need to happen if you had only one asset to worry about. But there is no real benefit for timing the market when you have a healthy selection of assets.
Examples of diversified investment portfolios
There are many ways to approach diversification in investing. Here are three samples portfolios that match investors with different risk tolerance and goals.
80% of an aggressive portfolio can be in a variety of equity funds. Out of that 80%, 45% can be in US equities (as it is the biggest economy), and 35% can be in foreign equities (emerging markets + developed markets).
The remaining 20% of the portfolio can be divided between bonds (10%), real estate (5%), and gold (5%).
A moderate portfolio can be:
- A variety of equity funds – 70%
- Bonds – 20%
- Real estate – 5%
- Gold – 5%
A conservative portfolio can be:
- A variety of equity funds – 60%
- Bonds – 25%
- Real estate – 7.5%
- Gold – 7.5%
Tips for diversifying effectively
Having learned the importance of portfolio diversification, you might also enjoy learning a few tips on how to do it effectively:
- Establish the timeline. Before moving capital around different asset classes, it’s important to set time-based goals. Your selection should consider that assets deliver benefits at different times.
- Always keep your risk appetite in mind. You also need to determine how much risk you’re comfortable with to decide whether to prioritize high-yield or low-yield investments.
- Mix conservative and high-growth assets. Let’s say you’ve decided to prioritize high-yield investments. That’s not the reason to miss out on more moderate opportunities.
- Think global. This will protect you from negative events taking place in one country or economy.
- Rebalance periodically. Change the size of your holdings depending on how they perform over time.
- Minimize overlaps. Diversifying is all about exploring new sectors, so make sure you’re not accidentally putting your funds in the same investment categories.
Learn about the sectors you invest in. No asset is worth investing in just because it’s new or different from your current holdings. It’s critical that you do research.