Portfolio diversification minimizes investment risks while increasing the chances of gaining huge returns when carried out in a disciplined manner.
FREMONT, CA: The practice of diversification is a risk management strategy that aims at spreading the investments in a way that the exposure of any one type of asset is limited. Diversification of assets can be the key to a growing portfolio or wealth over time while avoiding large losses. While there may be losses due to individual assets, it will be rare that two or three assets with different sources of risk and return will depreciate simultaneously.
There are various advantages of diversification, including exposure to more opportunities for return, minimization of the risk of loss to the overall portfolio, reduced volatility, and safety against adverse market cycles. Here are ways to diversify a portfolio.
Security diversification aims at increasing the number of stocks in the portfolio, thereby distributing the risk among the number of stocks. While the returns of better faring stocks are diluted by the other stocks, the losses of the ill-performing stocks are offset to an extent. In general, risk management is always countered by higher returns. Many professional investment managers tend to select only the stocks and bonds that they assume will return higher returns and neglect the securities that they expect to underperform. However, when it comes to security diversification in terms of earning huge profits, investors trying to make above-average returns also tend to take above-average risks.
A particular sector doesn’t always perform the same way at various points in an economic cycle. Certain factors and conditions can severely impact the performance of an industry in a short duration. Thus, it is recommended to distribute investment across various sectors. Even if one sector is affected by certain factors, investment in other sectors will not be affected. Thus, diversification across stock sectors enables to mitigate risks caused by disruptions in a particular sector.
Like diversifying investments across the sectors, it is entirely possible to do the same across the industries as well. It is not a good idea to overburden a particular industry with all the investments. For instance, if both company A and company B stocks are included in a portfolio and industry A companies go bankrupt, it will not necessarily impact industry B’s stocks. Thus, investments can be widely diversified, even within a particular sector.
Geographic diversification refers to developing portfolios that have both international as well as U.S. stocks. Like other diversification strategies, geographic diversification also promises lower overall risk levels than the ones invested in exclusively in one another. A seasoned investor can significantly benefit from investing in international stocks.
There are several ways of reducing investment risk by diversifying the portfolio. By taking a disciplined approach and using diversification, investments can result in extremely profitable returns with a minimized risk factor.