Diversification: Why What, How
Key Takeaways:
- Diversification is a strategy that aims to increase returns while reducing the overall risk
- You can diversify by investing in different assets like stocks, currencies, and cryptocurrencies
What is Portfolio Diversification?
Portfolio diversification is the process of spreading your money around various investments in order to mitigate risk and balance your exposure. While it may sound complex at first, portfolio diversification could be your greatest strength when you set out to trade and invest in the financial markets.
As a matter of fact, once you launch yourself into the markets, you will be overwhelmed by the wide horizons waiting for you.
There are hundreds of stocks available for trading, dozens of indices, and so many currencies and cryptocurrencies. And choosing your investments will invariably lead to relying on diversification in order to protect and grow your funds.
To this end, diversifying well will allow you to go into different sectors, asset classes, and individual financial products. Together, all of these will make up your diversified portfolio.
A Brief History of the Modern Portfolio Theory
“Diversification is both observed and sensible; a rule of behavior which does not imply the superiority of diversification must be rejected both as a hypothesis and as a maxim.” These are the words of the father of the modern portfolio theory, Harry Markowitz.
His paper on diversification called “Portfolio Selection” was published in The Journal of Finance in 1952. The theory, which helped Mr. Markowitz win a Nobel prize in 1990, posits that a rational investor should aim to maximize their returns relative to risk.
The most significant feature of the modern portfolio theory was the discovery that you can reduce volatility without sacrificing returns. In other words, Mr. Markowitz proved that a well-diverse portfolio would still hold volatile assets. But relative to each other, their volatility would be balanced due to the fact they all comprise one portfolio.
Therefore, the volatility of a single asset, Mr. Markowitz argues, is not as significant as the contribution it makes to the volatility of the entire portfolio.
Let’s dive in and see how this works and why it is important.
Why is Diversification Important?
Diversification is important for any trader and investor because it creates a mix of assets working together to yield high returns. In practice, all assets contained into your portfolio will be correlated in regards to the effect they have on your trading results.
However, these same assets out there in the market, may or may not be correlated. And this is what will allow you to reduce your overall risk profile.
With this in mind, the total return of your investments will depend on the performance of all assets in your portfolio. Let’s give an example.
An example of diversification at work
Say you want to own two different stocks, Apple and Coca-Cola. And in order to easily track your performance, you invest an equal amount of funds into each one: $500.
While you expect to reap handsome profits from both, Coca-Cola delivers a disappointing earnings report and shares go down 5%. Your investment is now worth $475, or 5% less.
Apple, on the other hand, posts a blowout report for the past quarter and its stock soars 10%. That would propel your investment to a valuation of $550.
So, how does your portfolio look now? In total, your investment of $1000 is now $1,025, or a gain of 2.5% on your capital. You have taken a loss in Coca-Cola but your profit in Apple has compensated for it.
Further, the more assets you add to your portfolio, the more complex the correlation would be between them. In practice, you could be diversifying to infinity. But beyond a certain point, however, diversification would be more likely to harm your portfolio, instead of helping you get more returns.
How to Diversify your Portfolio
The way to diversify your portfolio is to add a variety of different assets and see how they perform relative to one another. A single asset in your portfolio would mean that you rely on it entirely and how it performs will define your investment result.
If you diversify, however, you will have wider exposure to financial markets and ultimately enjoy more probabilities for winning trades, increased returns, and decreased overall risks.
In more detail, you can optimize your asset choices by going into different asset classes. The most popular of them include:
Stocks:
A great way to add diversification to your portfolio is to include stocks across the board. You can look virtually anywhere, US stocks such as technology giants, European car manufacturers, or travel-and-leisure companies.
Stock selection is among the most difficult and demanding tasks in trading and investing. But if you do it well, you will reap enormous profits.
Every sector, be it financial and banking stocks, or real estate, is fashionable at different times. Your job as an investor is to analyze market sentiments and increase your probability of being in the right stock at the right time.
Currencies:
The forex market is full of currency pairs floating at certain prices against each other. Trading currencies, for this matter, and having them sit in your portfolio, is another way to add diversification to your market exposure.
Cryptocurrencies:
A relatively new market, cryptocurrencies are quickly gaining traction. As they become mainstream, many newcomers join the market daily. Modern market strategists and analysts say adding crypto assets to your portfolio is a great way to diversify and shoot for long-term returns.
Advantages of Diversification
Building a diversified portfolio is one of the best and most popular forms of risk management. A well-designed diversified mix of stocks, currencies, and cryptocurrencies could reduce risk and increase expected returns. More precisely, the benefits of diversification include:
- Increased probabilities for higher returns
- Reduced risk of downturns and corrections
- Ability to move across different markets
- Ability to go short and long
- Ability to hold for short term and long term
Build Wealth Through Diversification
In the current context of market events, rising interest rates, and looming uncertainty, you need to be careful in your market approach. To this end, experts advise that the best strategy you could go with in order to build wealth is to have a well-diversified portfolio.
This portfolio would translate not only to asset classes, but also to financial products from different economies like currencies, indices, stocks, and commodities.
“Diversifying well is the most important thing you need to do in order to invest well,” says Ray Dalio, founder of the world’s biggest hedge fund Bridgewater Associates.
“This is true because 1) in the markets, that which is unknown is much greater than that which can be known (relative to what is already discounted in the markets), and 2) diversification can improve your expected return-to-risk ratio by more than anything else you can do.”
Diversification vs Concentration
The opposite of portfolio diversification is portfolio concentration. To illustrate, diversification means “don’t put your eggs in one basket.” Concentration, on the flip side, means “put all your eggs in one basket, and watch it carefully.”
In practice, concentration means focusing your investment on a single financial asset. Or you could have a few large bets that would assume higher risk but higher, or quicker, return.
While diversification is a recommended trading strategy for all seasons, concentration comes with bigger risks and is not always a good approach. Still, at times where you have conviction on a trade and have thoroughly analyzed the market, you may decide to bet heavily on it, thus concentrating your investment.
This said you need to be careful with concentrated bets as they can turn against your portfolio which would be exposed to higher risks. Diversification, however, promises to cushion your overall risk by a carefully balanced approach to various financial assets.
Summary
A diversified portfolio is essentially your best bet for coordinated and sustainable returns over the long term. Choosing a mix of various types of investments, such as stocks and stock indices, commodities, currencies, and crypto assets, would spread your exposure. Not only that, but it would also protect you from outsized risks, sudden economic shocks, or unforeseen events.
While you decrease your risk tolerance, you raise your probability of having winning positions. Regardless of your style and approach to the market, diversifying well will increase your chances of being right. You can be a trader and bet on currencies and indices of whole economies for the short term. Or you can be an investor and allocate funds to stocks and crypto assets for years ahead.
Potential sources of diversification are everywhere in the financial markets. And diversifying, according to experts, gives you hundreds, if not thousands, of opportunities to balance your portfolio and position yourself for risk-adjusted returns.
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