Why is Diversification Important in the Investment Process

Article about Why is Diversification Important in the Investment Process

Oct 12, 2020

As a newbie in the investment world, one of the first pieces of advice that you would get from experienced investors is that diversification is key to a successful investment process. This technique is crucial and almost mandatory to be implemented while investing in order to avoid and minimize risks and reach the investors’ financial goals. 

Diversification can help you increase your investment return with minimal effort on your part, but before we dive deeper into the importance of this process let’s examine the definition of portfolio diversification and its influence on the investment.

 

What is Diversification

 

In its essence, diversification is the most effective way of reducing investment risks through allocating different assets and funds in various financial industries or categories. In other words, a diversified portfolio allows you to increase your chances of a greater investment success due to the fact that you hold a mix of asset types that react differently to the unpredictable markets. 

For instance, in a better economy, stocks usually outperform bonds, while it is the opposite situation during an economic downturn. Therefore, holding both types of assets in your portfolio - stocks and bonds will reduce the risk of losing your investments. Simply put, diversification advises against “putting all eggs in one basket” situation. So, instead of investing in one type of asset, diversify your portfolio and get prepared by holding stocks, bonds, funds, and other assets that will all react differently to the market fluctuations. Moreover, diversification means to spread investments between platforms and to spread as much as possible between deals. 

 

Types of Risks and How They Influence the Investment

 

To better understand the portfolio diversification it’s important to be aware of the types of risks involved in the investment process. There are two main types of risks, one is a systematic risk also known as market risk, or undiversifiable and the other is an unsystematic or diversifiable risk. The first, as its name implies, is caused by the global situation and it directly affects the market and not just individuals or companies. The main factors that create systematic risk are political instability, inflation rates, war, and interest rates. Sadly, this type of risk cannot be eliminated, hence the inability to diversify the investments and minimize it. 

On the other hand, the unsystematic risk is specific to a company, industry, or market and this type of risk can be easily reduced through the diversification process. 

 

How to Diversify Your Portfolio

 

Even though diversification may seem like a complicated operation, in reality, it can be very simple. And contrary to some beliefs it’s not a numbers game. Not all investors who hold the most assets will eventually get a greater return on investment. 

The main trick to successfully diversify your portfolio is to own investments with different functions. Consequently, there are five major types of diversification. Creating a balanced portfolio by investing in different asset classes - stocks, bonds, exchange-traded bonds (ETFs) is the first type of diversification known as the asset class diversification. Next is sector diversification where the investor decides to diversify their portfolio within one specific asset class, specifically to invest in different sectors, such as residential, industrial, retail, etc. 

Another type of diversification is the one made on an industry level where the investment is diversified through various industries. Similarly, the geographical diversification is made based on the geopolitical and geographical risks by investing in different parts of the world. Lastly, a lesser-known method of diversification is the income profile diversification. This method is determined by the investor’s wealth goals where for a successful diversification it’s recommended to invest both in risky and in stable yielding income. 

 

Why is Portfolio Diversification Important 

 

If you still aren’t convinced that diversification is important in the investment process then here are a few reasons why you should consider diversifying your portfolio. Some of the main benefits of this process include:

  • Risk management
  • Greater opportunities for returns on investment
  • Reduces volatility 
  • Generates stable returns
  • Preserving your capital

 

Possible Problems with Diversification

 

Despite the numerous benefits of diversification, it is of prime importance to be aware of the possible problems that may occur during this process. For instance, a diverse portfolio may be unmanageable particularly if you hold multiple holdings or many big investments. Moreover, this can be a costly operation as various assets have different prices and not to mention the transaction fees that are inevitable. In that way, in the pursuit of higher returns, you may end up with much less than what you envisaged. 

 

Furthermore, trying some of the investment products created with the purpose of accommodating the investors’ risk tolerance levels may also be expensive or even too complicated for beginners. 

 

Bottom Line

 

Finally, it’s worth mentioning that the diversification of the investment portfolio doesn’t fully eliminate the risks. In particular, it is impossible to have any influence on the investment process when a systematic risk is involved. However, we can simply conclude that portfolio diversification in the investment process is critical for getting better chances of success and return on investment, meaning that no investor should neglect it and should implement it in the investment strategy.


Articles authored by Brankica Dimovska