Diversification helps an investor to minimize the risks of his investments by allocating funds among different financial instruments, sectors, industries, and categories.
The idea is to invest in different assets that would react different to the same event, so that the losses in one asset class get offset by the gains in another.
Most analysts and experts will tell you that although diversification isn’t a sure-ball way to mitigate losses, it’s still one of the golden rules when it comes to investing.
Types of Risks
Investors fight two main types of risks in their investing careers.
Systematic or Market Risk
The first type of risk is called the market or systemic risk, which is something that diversification doesn’t really solve.
Market risk is associate with every company. And among the common forces behind the risk are inflation rates, exchange rates, political tensions, interest rates, and wars.
In other words, systematic risks are not particular to a single company or industry. As since diversification cannot alone solve this, it’s a risk that an investor must accept.
The second type of risk is called unsystematic risks, and the good news is that proper diversification can fight it.
This type of risk is specific to a company, market, economy, industry, or country. The most common causes of unsystematic risks are business risk and financial risk.
Therefore, diversification will help the investor fight unsystematic risks by investing in various assets so they will not be all affected in the same way by the market events.
It’s important to diversify across the board, meaning you should be contended in diversifying across different companies. You should also diversify across many industries. If your stocks are very uncorrelated, then it’s much better.
To take that a step further, you should diversify among different asset classes. That means you should not only invest in stocks, but also assets like bonds and currencies. These assets do not react the same way to the same market events.
Having a combination of these assets on your portfolio will reduce your holdings’ sensitivity to disruptive market events.
For example, bonds and stocks generally move the opposite directions. If a certain event pummels the value of stocks, you can be sure that your bonds will appreciate, and vice versa.
Also, you should consider the location of your assets. The market events in the United States do not necessarily affect asset movements in other parts of the world.
Challenges to Diversification
Even though there are many real benefits to diversification, downsides and challenges also exist. For instance, it may be an overwhelming task to manage a portfolio that has a lot of assets in it.
At the same time, not all investment assets cost the same. That means buying or selling them require particular attention from you.
Overdiversification is also a thing. While owning a diverse set of assets is truly better than owning just one, there is a point when adding more to the holding no longer makes sense.