One rule of smart investing is diversifying your investment portfolio. Portfolio diversification involves investing your money in different assets to reduce the overall risk. Instead of investing in stocks for one company, for example, you can buy stocks of companies in various industries. A famous analogy for portfolio diversification is carrying your eggs in different baskets. As such, if one basket breaks, eggs in the other baskets are still good.
Importance of Portfolio Diversification
1. Mitigates unsystematic risk
Portfolio diversification limits the exposure of funds to risk, specifically unsystematic risk. Unsystematic refers to the risk that is specific to a given market segment or company. Thus, if all your investments are in a particular company or sector and the market events are unfavourable, then all your investments are affected.
With portfolio diversification, you can mitigate the risk of the securities by investing in different asset classes or industries. Different securities or asset classes have lower correlations, meaning they move in different directions. It means that if security A performs in a specific way in the market, then security B should perform in the opposite direction for the risk to be reduced.
Although portfolio diversification does not eliminate systematic risk, which is an inherent risk for the market at large, it affects unsystematic risk that is controlled as it is firm-specific.
2. Earning Stable Returns
Investment assets perform differently depending on market conditions and other factors. A diversified portfolio allows one to earn stable returns regardless of these conditions.
For example, equities tend to outperform bonds in a growing economy, while bonds will outperform stocks when the economy is slowing down. By building both bonds and stocks in your portfolio, you enhance its returns regardless of the market direction. If the bonds are not performing well, you will still earn a return from the equities compared to holding a portfolio with bonds only.
3. Preservation of Capital
By reducing your exposure to market volatility, portfolio diversification will help you preserve your capital. Some investors, especially those close to their investment goals, like retirement, focus more on preserving capital rather than the accumulation of capital.
If your goal is to preserve capital, diversifying your portfolio ensures you do not lose all your money.
How You Can Diversify Your Portfolio
1. Diversification Across Asset Classes
This entails the allocation of portfolio funds across different investment vehicles such as:
- Shares or equity for companies that float their shares to the public.
- Commodities- which are goods that are necessary for production such as cotton and precious metal.
- Bonds – fixed-income debt instruments from government or corporates.
- Cash and cash equivalents – that are short-term in nature and include treasury bills, money market instruments, and certificate of deposit.
- Real estate involves investment in buildings, land, and natural resources.
- Exchange-Traded Funds entail investments in securities that are based on an index, sector, or commodity.
Related: types of investment assets in Kenya
2. Diversification Across Sectors
If you are only comfortable with one asset class, you can achieve diversification by focusing on different sectors. For example, an investor who wants to invest only in real estate investment can allocate different portions to office, residential, industrial, and retail sectors. If you are focusing on stocks in the technology industry only, you can diversify across software and services, and hardware and equipment sector, among others.
As long as the investment is in securities with a negative correlation, you have achieved portfolio diversification.
3. Diversification Across Industries
This type of diversification involves the injection of funds across different industries such as manufacturing, technology, farming, and medicine. For this, there is a lower correlation of securities with each other, and thus the risk is minimized. Investment in stocks for companies within the different industries eliminates that unsystematic risk through the strong performance of stocks from other industries.
4. Diversification Across Markets
It involves diversifying across foreign markets and not just focusing on domestic markets. The advantage of this type of diversification stems from the fact that investment in foreign securities brings about a negative correlation with domestic securities.
For instance, investing in securities that are in the US or UK will have a negative correlation with those in Kenya if there is a major economic event that is affecting Japan’s stock market.
Disadvantages of Portfolio Diversification
Portfolio diversification can often be a complicated and time-consuming endeavour. One needs to research as much as possible on all the assets for proper asset allocation. It also requires active management and rebalancing to ensure your portfolio remains within your investment objectives and goals.
2. Additional Costs
Due to active management, diversification can cost you some extra fees to cater to the constant buy and sell transactions.
3. Restricted Gains
Given that allocation of funds in different securities is of a specific percentage, then profits gained from a spike are limited to that extent. Investors might feel that this constrains their potential for obtaining total gains.
4. Increased Risks
Yes, diversification can increase risks in your portfolio when you stack up assets you know nothing about. Do not buy assets just for the sake of diversifying the portfolio without doing any due diligence or understanding the asset.
Portfolio diversification helps minimize exposure to risks and market volatility to the minimum possible levels. You are, therefore, able to earn good returns without being completely submerged due to a major event. Also, you do not need to constantly worry about your securities as they can weather market cycles. But that does not mean over-diversifying your portfolio with assets you do not understand.