Whether you’re a seasoned trader or a novice still learning the ropes, you’ve probably heard of portfolio diversification and its importance in trading and investment.
A diverse investment portfolio is protected from volatile price movements and market fluctuations.
For this reason, traders have devised various diversification strategies to help secure their investments in a way that best suits their style.
In this article, you’ll learn about the different ways to diversify your investment portfolio and what you should avoid doing when diversifying.
But before delving into a discussion of diversification strategies, you should be familiar with the concept of portfolio diversification and its importance in risk management in investing.
Defining Portfolio Diversification
Portfolio diversification is the investment equivalent of not putting all your eggs in one basket.
Simply put, it means including a mix of various asset types in your investment portfolio rather than sticking to just one.
The principle behind diversification is that a portfolio using different types of assets will give higher returns in the long run.
While diversifying your portfolio can – on average – yield higher returns, it is just a secondary benefit of the practice.
The primary reason why investors diversify investment portfolios is to reduce their risk exposure and how much they are affected by volatility.
Because no one can accurately and consistently predict future market conditions, spreading investments across several different assets is a prudent move.
To better understand diversification and how it protects against price movement volatility, look at the example below.
Investor A has a concentrated portfolio with only assets from the travel and tourism sector. When lockdowns were implemented worldwide during the COVID-19 pandemic, Investor A’s entire portfolio plummeted.
Meanwhile, Investor B diversified his portfolio and has stocks in travel and tourism, technology, and digital streaming sectors.
While Investor B’s travel and tourism stocks were likewise negatively affected by the pandemic, his stocks in both tech and digital streaming soared, covering his losses from the former.
From the above scenario, you can see that Investor B’s choice to diversify his investment portfolio helped him weather the downturn caused by the pandemic.
By investing in negatively correlated stocks, Investor B essentially gained in one stock what he lost in another.
How to Measure Portfolio Diversification
Measuring exactly how diverse an investment portfolio can be virtually impossible due to the myriad of variables involved.
Despite this, there are a handful of methods portfolio managers use to get an idea of how diverse a particular investment portfolio is.
These measurement techniques include:
Correlation Coefficient
This method compares the relationship of two variables. It works by tracking the variables’ movements and noting whether they move in the same or different directions.
The correlation coefficient results are displayed as a value between –1 and 1. Values closer to –1 denote strong diversification.
Values closer to 0 indicate a moderate degree of diversification. Lastly, values closer to 1 are signs of an investment portfolio lacking diversity.
Standard Deviation
Analysts use standard deviation (SD) to gauge portfolio diversification by measuring a given asset’s annual returns against the mean.
A higher standard deviation translates to more varied returns and signifies low levels of diversification.
In contrast, a more diversified investment portfolio would give returns consistently closer to the average returns of particular assets.
Counting/Weighing
Portfolio managers can also determine portfolio diversification by counting the number of assets or knowing each asset’s weight.
Counting the number of assets in a portfolio is very straightforward. Investors simply note how many equities they hold and how many of each equity is in a given sector.
For instance, an investor can count that he holds 20 equities, and 10 of those are in the technology sector.
Alternatively, they can also gauge portfolio diversification by assigning percentages to each investment. In the previous example, the investor with 20 equities in tech has 50% of his portfolio in a single sector.
Different Diversification Strategies for Your Investment Portfolio
There are various techniques you can use to diversify your investment portfolio. These diversification strategies include:
Diversification Strategy #1: Asset-class Diversification
You can diversify your investment portfolio by spreading your funds across different assets. Allocating your funds into various assets protects you from losing all your money in a single market. It can also help you regain losses from one asset with gains from another.
The principle behind this is that factors that negatively affect one asset will not necessarily affect all others and may even benefit some.
Some asset classes you can diversify into include:
- Stocks
- Bonds
- Real estate
- Exchange-traded funds (ETFs)
- Commodities
- Cash and short-term equivalents (CCEs)
Diversification Strategy #2: Diversifying Across Sectors/Industries
Similar to assets, different sectors are not affected by and react to external factors in the same way.
For instance, the COVID-19 pandemic that devastated the global travel and tourism industry made the tech and communication sectors soar.
Asset allocation across negatively correlated industries can help protect you from taking the brunt of economic downturns that impact one sector.
Diversification Strategy #3: Geographic Diversification
You can also consider asset allocation across different geographic regions (i.e., investing in foreign securities).
The reason behind geographic diversification is similar to why investors spread their investments across different sectors: forces negatively impacting one country will not necessarily affect others.
For instance, factors causing the US economy to decline may not be present in Japan. Therefore, investors with both US and Japanese securities have a layer of protection during economic downturns in the US or vice versa.
Moreover, investing in emerging economy countries can provide higher returns than developed countries, albeit with higher risk levels.
Common Mistakes in Portfolio Diversification
Diversifying your investment portfolio is helpful for investors. However, incorrectly doing it can prevent you from achieving a balanced investment portfolio.
Below are some of the most common errors investors make when diversifying:
Over-diversification
While diversifying your investment portfolio can help you with risk management in investment, overdoing it can become counterproductive.
Over-diversification gives diminishing returns and further reduces the returns you’ll get without providing commensurate gains.
Over-diversifying also increases the amount of data you need to monitor and the time you need to invest – all without added benefits.
Ignoring Correlations
Diversification strategies are designed to help investors reduce risk exposure. These techniques bank on the low or negative correlation between particular assets.
When you neglect to pay attention to the correlation between the assets you’re diversifying into, you ignore the principle behind diversification and make the whole process pointless.
Regardless of how many sectors or funds your funds are spread on, it is meaningless if they correlate.
Overdependence on Diversification
Depending too much on portfolio diversification – to the detriment of other risk management factors – is another pitfall in portfolio management.
You need to keep an eye on other elements when managing the risks in your investment portfolio. Factors you need to watch out for include:
- Macro considerations – These include everything that happens in the larger global economy. Examples of macro considerations are business cycles, political environments, and consumer sentiment.
- Sector performance – This involves analyzing specific sectors and how they are affected by and perform in particular market conditions. When analyzing sector performance, investors need to consider the various factors that can potentially impact each industry (e.g., seasonality, shortage in supply or demand).
- Credit risk – This pertains to the financial solvency of a given company. Credit risk analysis aims to know if companies can continue paying their bills and avoid bankruptcy. It is a concern for investors as they may lose all capital investments in a company if it goes bankrupt.
- Liquidity risk – This refers to the timeframe involved in converting a particular asset into cash. Illiquid assets can give investors losses when they need to raise cash quickly, as these assets often need to be sold at lower-than-market value.
Tools You Can Use to Diversify Your Investment Portfolio
Given the importance of portfolio diversification, software tools designed to help investors manage diversification are abundant in the market.
Some of the most popular portfolio diversification software include:
Quicken
Established in 1982, Quicken is among the oldest diversification tools available today. Since its introduction, Quicken has improved and added helpful features like planning reports and sample investment analysis.
Sharesight
Introduced in 2008, Sharesight is popular among global and domestic traders alike.
Sharesight has a tracking reports feature that lets users keep track of multicurrency valuation, multi-period portfolio comparisons, and asset allocation, among other things.
Empower
Formerly known as Personal Capital, Empower gives users access to a robust platform for investment management with a freemium model.
Its various features include:
- Cash flow analysis
- Asset allocation views
- Retirement planner and fee analyzer
- Investment checkup
How Portfolio Diversification Protects Your Investments
Diversifying your investment portfolio helps you avoid losses during economic declines and industry disruptions. Aside from this, portfolio diversification also gives you bigger returns in the long run.
With a balanced investment portfolio, you can rest assured that your financial investments are secure and have larger chances of weathering recessions.
