Why is Portfolio Diversification Important
Detroit, MI
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December 20, 2022 08:17 AM Eastern Standard Time
Although you may hope that all of your investments will increase in value, some of them are bound to decline. If that happens, you'll need a diversified portfolio to compensate for the loss.
Diversification is essential to avoid having your portfolio concentrated in too few investments.
Take a look at the importance of portfolio diversification, how it works and ways to increase diversification.
What is Portfolio Diversification
Portfolio diversification is an investment strategy that aims to reduce overall portfolio risk by distributing investments across multiple asset classes, sectors and geographic regions. The goal of portfolio diversification is to ensure that a portfolio contains a mix of investments that will perform differently across economic conditions, reducing the risk of losses due to any one particular asset.
A wide variety of assets — such as stocks, bonds, commodities, real estate, cash and private alternative investments — should be considered when constructing a diversified portfolio.
How Portfolio Diversification Works
By carefully selecting a mix of investments with low correlation and diverse risk profiles, investors can achieve a portfolio that generates returns even when some investments perform poorly. Diversifying your portfolio potentially enables better performance under different market conditions, which can increase returns over time.
When diversifying, investors should consider their own risk tolerance and goals. For example, a conservative investor may choose a portfolio heavily weighted toward fixed-income investments. In contrast, a more aggressive investor may opt for a portfolio with a higher proportion of riskier opportunities, like venture capital.
Investors should also factor in their time horizon and liquidity needs to ensure that the portfolio suits their circumstances. Overall, portfolio diversification requires selecting investments that are not heavily exposed to the same risks.
Why is Portfolio Diversification Important
Investing in a portfolio that is not diversified can expose you to unnecessary risk. Investing risks can be broadly classified into systematic and unsystematic risks.
Systematic risks refer to market risks caused by socioeconomic events such as recession, inflation, volatile commodity prices and international conflicts. Because these factors generally affect the financial markets, systematic risks are not easily mitigated by diversifying within public markets like equities and fixed-income products.
Unsystematic risks are specific to individual companies or sectors. Unsystematic risks could be the result of changes in regulation, intense competition, product recall or government nationalization.
Investors can reduce unsystematic risk by pursuing a well-diversified investment portfolio. By diversifying a portfolio across different industries, an investor can minimize the potential losses when an unsystematic risk event triggers a decline in a particular asset.
Diversifying a portfolio can reduce the overall volatility of the portfolio, along with providing investors access to different types of investments and opportunities.
4 Benefits of Portfolio Diversification
Here’s what you can gain from diversifying your portfolio:
Reduced risk: Spreading your investments across multiple non correlated opportunities reduces the risk of declines in any single asset. Diversification minimizes concentration risk within your portfolio.
Increased returns: By diversifying your portfolio, you can generally improve risk-adjusted returns. Adding diversified options could also allow you to capitalize on investments with higher returns.
Protection during market volatility: When markets are volatile or experiencing downturns, diversifying your portfolio can help protect against losses as the value of some investments may decrease while others remain relatively stable or even increase in value.
Broader range of investment opportunities: Portfolio diversification allows investors to take advantage of investment opportunities that may have otherwise been unavailable because of limited capital or other restrictions.
Strategies to Increase Diversification
When done correctly, diversification can actually increase overall returns as it increases the likelihood of finding higher-yield assets.
Allocate to Private Markets
Allocating a portion of your portfolio to private markets, such as venture capital and private equity, can be an effective strategy for increasing risk-adjusted return. Private market investments may offer higher potential returns than traditional public market investments.
As a result, institutional pensions and endowments have been steadily increasing their allocation to alternatives. For example, the Yale endowment fund allocates most of its investments to nontraditional asset classes because of their return potential and diversifying power.
Diversify Across Geographies
In addition to diversifying across asset classes, it can also be beneficial to invest in different geographical markets. Investing in companies or assets based in multiple countries can help reduce portfolio risk by offsetting market fluctuations resulting from economic and political changes in any single region.
Invest in Different Themes
Investing in growth, income-producing or value strategies can help reduce portfolio risk by ensuring that your portfolio is not overly exposed to any single style or sector of the market. You can also invest directly in diversified alternative investment portfolios that generate income across specialty finance holdings.
Use Alternatives to Diversify
The primary benefit of diversifying your portfolio is to reduce risk without sacrificing potential returns. By investing in a range of different asset classes, sectors and geographical markets, investors can spread their risk while taking advantage of opportunities in each sector.
Alternative investments are often less correlated with traditional assets like stocks and bonds. Examples of alternative investments include private equity, real estate, venture capital and art.
Because of their poor correlation to the general market, alternative investments can potentially mitigate both systematic and unsystematic risks. Systematic risks like inflation can increase the appeal of alternatives like real assets like real estate or art.
Many alternative investments used to have a high entry barrier requiring minimum investments of hundreds of thousands or millions of dollars. The field of attractive private market opportunities has been growing and is now increasingly accessible to all investors.
This post contains sponsored advertising content. This content is for informational purposes only and is not intended to be investing advice.
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