In finance, diversification refers to the strategy of investing in many different areas to protect against risk. This may include investments in different companies, different markets, or using different types of accounts. When your investment portfolio is diversified, your investments will be less affected by volatility in any one sector or portion of the portfolio. This helps protect investors against risky investments and loss, but is also usually accompanied by more moderate growth potential.
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Advantages of Diversification
One of the main advantages of diversification is that it shields the investor from risk. Even if one investment or type of investment fails, the investor’s portfolio won’t go down with it. This protection against risk also enables investors to pursue riskier investments that may offer the promise of a higher return, since their portfolio as a whole is invested responsibly across a variety of different markets and investment types.
Disadvantages of Diversification
There are plenty of advantages to diversification, and smart investors are wise not to put all their eggs in one basket. However, there are some downsides to diversification, including reduced short-term gains.
Diversification protects against market volatility in either direction — diversified investment portfolios will be protected from sudden, precipitous losses, but they’ll also be shielded from sudden growth. Diversified portfolios represent a moderate approach to investing, which insulates investors from the dramatic highs and lows that may come with investing in single markets or stocks.
Another potential disadvantage of diversification is that it can become unwieldy to manage over time. Investors with extremely large and diverse portfolios may benefit from an investment manager who can oversee their investments and ensure that they are appropriately diversified.
There are many ways in which a savvy investor can diversify their investments, including stock diversification, diversified mutual funds, and diversified retirement funds.
Historically, domestic stocks in the United States have experienced steady growth over time, making them a great investment option for a growth-oriented portfolio. In the short term, however, stocks can be volatile, so investors who need to use that money in the near future should invest with care. By investing in a variety of different stocks in different industries and with different levels of risk, investors can help to protect their portfolios from market volatility.
In addition to domestic stocks, investors can further diversify their portfolios by investing in foreign stocks. Like domestic stocks, these investments are both high risk and high reward. Because international markets are often affected by different economic factors than domestic markets, they can protect your investment against economic downturns localized in the United States.
Diversified Mutual Funds
Mutual funds are another great option when it comes to diversifying your investment. Mutual funds are automatically diversified and pool investors’ money to invest in a wide range of different vehicles. Mutual funds are also typically operated by professional money managers, making them an easy way for individuals to diversify their investments without the help of a paid professional.
When it comes to mutual funds, there are a variety of different kinds:
- Index funds track the overall growth of the market, and are often aligned with major market indexes such as the S&P 500 or the Dow Jones Industrial Average.
- Equity funds are one of the most common types of mutual funds, and invest in a variety of stocks with different market caps and levels of risk.
- Fixed-income funds target investments with a set rate of return, such as government bonds.
- Balanced funds invest in both stocks and bonds, and are sometimes referred to as asset allocation funds.
- Money-market funds make short-term, low-risk investments, such as Treasury Bills.
- International funds invest in markets outside of the United States, and help to protect investors from the risk of investing only in domestic markets.
- Other specialty funds can include funds that focus on a particular economic sector, geographic region, or socially responsible companies.
Diversified Retirement Funds
Retirement funds offer yet another opportunity for investors to diversify their investments. Individuals can invest their savings in a variety of different retirement funds according to their age and investment strategy. There are a number of diversified retirement fund options, many of which are offered as part of 401(k)s:
- Target-date funds vary the level of risk depending on the investor’s age, with older investors exposed to less risk than younger investors.
- Mutual funds are one of the most common retirement fund vehicles, and are already diversified in terms of their investments.
- Other asset classes, including bonds and short-term investments, are another way to diversify retirement investments.
Various investment strategies enable investors to diversify their portfolios and protect against risk.
Modern Portfolio Theory
Modern portfolio theory is designed to maximize returns according to a certain level of risk. Since risk is usually unavoidable when dealing with investments with high returns, modern portfolio theory allows investors to evaluate investments based on both their level of risk and expected return.
Investments that provide a relatively high expected return for a proportionally low level of risk occupy a trend of optimal portfolios known as the “efficient frontier.”
Smart Beta Theory
Related to modern portfolio theory, smart beta theory attempts to increase both diversification and return using a strategy that focuses on exploiting market inefficiencies. Rather than just tracking standard market indexes like the S&P 500, smart beta also takes into consideration factors such as volatility, liquidity, value, size, and momentum. Funds that use the principles of smart beta theory include the Vanguard Value Index Fund ETF (VTV) and the Vanguard Dividend Appreciation Index Fund ETF (VIG).
Whether you’re planning for retirement or just want to grow your investments in a responsible way, diversifying investments is a great way to protect against risk by spreading your investments over a variety of different markets and asset classes.
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