Updated Feb 20, 2022

What Is Diversification?

What Is Diversification?

Introduction

Diversification refers to a strategy of risk management that is about merging different investments in a portfolio. The expanded portfolio is a combination of different types of assets and investment vehicles to restrict the disclosure to anyone. The logic that inspires this is that when a portfolio is made up of various assets, it brings in higher long-term returns (on average) and reduces the risk for an individual with security or holding.

Investors are interested in diversifying their investments athwart asset classes and showcase the percentage that each investment gets in that portfolio. These asset classes are:

• Bonds
• Shares
• Exchange-traded Funds (ETFs)
• Real Estate
• Short-term Cash Equivalents (CCE) and Cash
• Commodities

Overseas Diversification

Foreign securities could further give investors diversification benefits as these overseas securities are less correlated with the native securities. Instance- the market forces that might affect the Indian Economy might not affect the American Economy in the same manner. Thus, the purchase of assets in the US provides the investor with small security when the Indian Economy hits an economic downturn.

Stepwise diversification

Here are a few steps that are required to understand diversification:

• Risk Appetite

It refers to the money that the investor could manage to lose. The investor must be one with a high-risk appetite to afford short-term fluctuations and to possess enough money to afford when such fluctuations hit them and get through with it. Being prepared for investment loss does not indicate that investments result in risks, but it is better to be ready for any losses with a higher risk appetite.

• Investments and Risk Appetite

When an individual is aware of the potential risk appetite, they could then take up the investments in accordance with it. The diversification, therefore, happens as in corresponding to these risks appetite and related investments.

• Portfolio

An investor must build a portfolio that includes different instruments of investment. These could be, for instance, such as stocks or bonds, etc.

• Different industries

Diversification might also include investing in different industries or sectors. Therefore, it is essential and logical to choose securities for diversification according to industries with much thought and reasoning to control or balance the industry risk.

Importance of diversification

Diversification is one of the essential characteristics in investing because of the following reasons:

• Different asset classes are protected in the portfolio because of diversification, which leads to the portfolio's growth.
• Diversification helps improve the investors' knowledge as now the investor could invest in a variety of streams and have more investment choices. In addition, this knowledge leads to better market updates for the investor.
• Not just different streams, but the diversification also awakens the investors about varied investment strategies. Thus the investors explore different investing approaches varying from value-focused to growth-focused.
• The overall risk of any investment is reduced by investing in a portfolio.

Disadvantages of Diversification

• Time-consuming

As the number of portfolios increases, the time taken by these portfolios for their management also increases.

• Expensive

The purchase and selling of portfolios might come as expensive to the investors which includes transaction fees and brokerage commissions. So it can be said that diversification, although it comes with lesser risk, also comes with lesser rewards.

• Limited returns

For as mentioned earlier, diversification does not offer you that much of a reward.  Hence, to have a much higher reward, it becomes mandatory for higher risk investments, and this risk might not be for everyone and thereby might limit the returns of the investors.

• No Loss Prevention

Diversification has not been proved to be able to prevent a loss altogether. At best, it could only reduce the impact of any fraud and poor information in the investor's portfolio.

Conclusion

Diversification aims to smooth out the risks in the portfolio that might appear unsystematic, which helps balance out the negative performance of one investment by the positive performance of another investment. The advantages of diversification come into force only when the securities are not very much correlated in the portfolio that the market influences each one of them mainly in opposite ways.