Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains ...
The Basics of Diversification
Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.
Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. The investing in more securities generates further diversification benefits, albeit at a drastically smaller rate
Foreign Diversification
Investors can reap further diversification benefits by investing in foreign securities because they tend to be less closely correlated with domestic ones. For example, forces depressing the U.S. economy may not affect Japan's economy in the same way. Therefore, holding Japanese stocks gives an investor a small cushion of protection against losses during an American economic downturn.
Diversification and the Retail Investor
Time and budget constraints can make it difficult for noninstitutional investors—i.e., individuals—to create an adequately diversified portfolio. This challenge is a key reason why mutual funds are so popular with retail investors. Buying shares in a mutual fund offers an inexpensive way to diversify investments.
While mutual funds provide diversification across various asset classes, exchange-traded funds (ETFs) afford investor access to narrow markets such as commodities and international plays that would ordinarily be difficult to access. An individual with a $100,000 portfolio can spread the investment among ETFs with no overlap.
Disadvantages of Diversification
Reduced risk, a volatility buffer: The pluses of diversification are many. However, there are drawbacks, too. The more holdings a portfolio has, the more time-consuming it can be to manage—and the more expensive, since buying and selling many different holdings incurs more transaction fees and brokerage commissions. More fundamentally, diversification's spreading-out strategy works both ways, lessening both the risk and the reward.
