Diversification is a risk management strategy widely used by investors, but how is diversification achieved? That’s what this blog post is about.
Perhaps one of the most important things you can do to ensure proper diversification is to invest in non-correlated or even inversely correlated assets. If you choose to adopt diversification as an investment strategy, you’ll want to find investments that counterbalance each other.
Investors with diversified portfolios expect the positive performance of some investments to neutralize the negative performance of others. If something goes wrong with one of your investments, another asset’s yield should hopefully make up for it or at least not decline as much.
Before we go over different strategies, it’s important to keep in mind that diversification is not risk-free. It won’t ensure gains or guarantee against losses. You should always consider your particular situation and investment objectives.
Diversification across asset classes
One way to diversify is by spreading your investments across multiple asset classes – stocks, bonds, ETFs and REITs, for example. This provides investors with an opportunity to have exposure to assets with different risk-reward ratios and variable liquidity.
It also might make sense to keep some of your money in cash in order to have the necessary liquidity in case of an emergency or unexpected investment opportunity, for example. Warren Buffett, for instance, is known for having billions of dollars in uninvested cash, just waiting to be deployed when he believes it should.
Diversification across industries
Investing across multiple industries such as technology, consumer staples, and energy, can be a good way to better protect yourself from unsystematic risk (risk that is specific to an asset or industry). Unsystematic risk can come in many forms, such as new regulation, emerging competitors or a shift in a company’s governance structure, for example.
Diversification across geographies
By investing both locally and abroad, you potentially lessen the portfolio risk that is particular to a country or region. The economy in Venezuela or Argentina might be facing an economic downturn, but the US or Europe might be doing just fine, for example.
Some investors diversify geographically by investing in exchange-traded funds that focus on specific markets such as Brazil or China. You don’t have to invest in multiple stock exchanges in order to have a globalized portfolio.
Disadvantages of diversification
As explained in another blog post, diversification does not guarantee investors will not lose money and this kind of investment strategy doesn’t make portfolios immune to risk – especially when it comes to systemic risk (which affects a market in its entirety).
Moreover, although diversification can reduce risk, it can also reduce reward. By reducing your exposure to any single investment and protecting you on the downside, diversification limits you on the upside as well.
If you choose to adopt diversification as a portfolio management strategy, remember to consider your particular situation and investment objectives.
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