What Is Diversification?

This is a means of spreading your investment around other available portfolios to avoid the effect of price volatility on your investment. Diversification in the stock market is used to reduce risk and to maximize the return from the various available investment opportunities. Most successful investors and investment advisors would agree that although diversification does not shield the investor against loss, it is an easy way to reach one's financial goal while at the same time minimizing the level of risk. Diversification does not guarantee that the investors would not face any risk, rather it shields investors from the dangers associated with risk and market volatility. 

However, there are some conditions for diversification. The first is that as an investor before engaging in diversification you would have to learn how to balance your comfort zone with risk. This simply means that you find a way not to invest too conservatively or too aggressively. Investing too conservatively might expose your savings to market volatility while investing too aggressively might rid you of the value of your assets to the extent that recouping your loss might become a hard nut to crack. The simplest way to avoid either of the two options is to diversify.

Though diversification could mean a lot of things in the business world, it is one of the most effective ways to mitigate your investment against risk and volatility. It is a way of spreading your investment portfolio across other available assets. Diversification does not guarantee against loss or ensure a profit. It only reduces the risk of facing too many risks by controlling some of the risks, especially the individual risk. 

Why You Should Diversify

• The first important reason you should diversify is, diversification provides a hedge against profit loss. With your stocks spread around, your cash out would be higher than when you have just a single investment portfolio.
• Secondly, diversification is a way not to be involved in either of the two extreme types of investment, that is, investing too conservatively or too aggressively. Diversification produces a balance between these two.  For instance, assuming you have a portfolio of stock with a particular company and this is the only investment portfolio you have. Then after some time, the company announced that they would be going on an indefinite strike. The share prices of the company's stock would drop and this would inadvertently affect your stock with the company.
• However, if you have other investments in other companies, the effect would be on a part and not all of your investment. In fact, there is a good chance that investment in the other company would take rise as a result of the drop in the first company. In this case, your investment in another company would cover the risk in the first company.
• You can even diversify to other companies and platforms because there is a good chance that this would negatively affect not just the first company.
• A combination of diversified portfolio can help to reduce the effect of risk and portfolio sensitivity to market swing.

The Four Basic Components Of Diversification 

• Domestic Stock

Because stock generally attracts more volatility than other investments portfolio, diversification is mostly carried out in stock investment. Added to this, the stock is one of the investment portfolio investors are often aggressive with because of its great opportunity to change one's story. There are lots of successful investors today who made their money from stock investment. However the higher the chance of gaining more wealth in stock investment the greater the risk of losing out, especially if you are cashing out at a very short period of time. 

• Bonds

Usually, bonds provide their investors with regular interest income. This is why in contrast to stock, bonds are considered to be less volatile. Also, its way of responding to market issues is different from that of stock and most time, investors used this plan to shield themselves against the inevitability of stock investment. For an investor that is more concerned with safety than growth, T- treasury bond is the most sought after. This would help investors reduce their exposure to stocks. However, while bond volatility is generally more reduced than stock, the payout in a bond is often lower than the payouts in stock. 

Although there are other bands like international bonds and high-yield bonds that can offer high payout, this is usually accompanied with more risk than others whose payout is very low. 

• Short-term Investment

A short-term investment entails short term CDs (certificate of deposit) and money market funds. The money market fund is very good for investors who are looking for a means to preserve their principal. It is a very conservation investment portfolio and offers easy access to money. However, while the risk involves in the operating money market is generally low, it pays far below stock and even below bonds. Also, the money market is no guarantee or insured by the Federal Deposit Insurance Corporation(FDIC) like CDs. In CDs, the liquidity offered by the money market is not offered.

• International Stock

This is an act of investing in international stocks, that is, stock outside one's country of origin, nationality. It involves stocks operated by another country. In most cases, the operation and management of these stocks are different. Stocks from other countries aside the United States of America offers different operation procedures and exposure to the opportunity that might not be available in the US stocks.  If you are interested in trying out an investment with higher opportunity and return with higher risk, you might try out international stocks.

More Components Available For Diversification

• Sector Fund

This type of investment focuses on a particular segment of the economy. Its method of operation is the same as stock. In fact, a sector fund is a form of stock investment that focuses on a particular section of a country's economy. It is advisable for investors who want to spread out their investment into various phases of the country's economy to try out this type of investment. The payouts in this type of investment are determined by how stable the economy of the country is.

• Commodity Focused Fund

It is advisable that before investing in commodities, you should gain experience from other types of investment portfolios. This would give you background knowledge and experience about how diversification works. Commodity-focused investment is a way to add equity funds into your portfolio. Commodity investment funds include mining, oil and gas, and natural resources. It is one of the surest ways to contain the effect of inflation on an investment.

• Real Estate Fund

This encompasses all real estate investment trusts (REITs). It is also another effective form of diversification and can also provide protection against the risk of inflation.

• Asset Allocation Funds

Asset allocation funds are very good for investors who are too busy to try out diversification of investment portfolios. The asset allocation fund is a very good single opportunity investment strategy. Part of the assets under this fund is managed by fidelity. 

Disadvantages of diversification

While there are lots of advantages of diversification, diversification also has its disadvantages. One of these is that managing diverse portfolios can be very difficult in diversification, especially if you have other investments and holdings.

Also, in practicing diversification, it is important to note that not all investment portfolio comes out the same way. This simply implies that portfolios in diversification have varying buying and selling cost, from transaction fee to brokerage charges, diversification cost a lot of money that might end up creating a dent in the investors' bottom line. Also since the level of risk is determined by the potential of getting more money, the cash out might not be worth it.

Another very popular risk in diversification is undiversification. This is also known as market risk or systematic risk. This type of risk is not limited to diversification, it also cut across every company. The common cause of systematic investment is political instability, inflation rate, interest rate, exchange rate, and war. Since the risk is not limited to a particular company or investment, it cannot be reduced by diversification. It is a risk every investors must confront.

Also, there is the diversifiable risk. This is also known as unsystematic risk. It is the opposite of undiversifiable risk. This implies that while market risk or systematic risk is not restricted to a particular company, the diversifiable risk is restricted to a particular company. The commonest cause of this type or risk is financial risk and business risk. Diversifiable risk can be controlled or avoided by diversification. Therefore, by investing in different platforms, an investor can contain market risk.

Risks Involved in Diversification 

Usually when people are getting into an investment, their goal borders on the amount of money they would make from the investments and how they would use the money. Many people don't take into consideration the two vital things to consider in every investment. These two things are the number of years it would take to get the profit on the investment, this is also known as time horizons and your attitude as an investor, also known as risk tolerance.

For instance, assuming your time horizon is 25 years from the period of investment, because the time horizon is fairly long, you can diversify into small-time horizon investment while still looking forward to the long time goal.

However, before going into diversified funds, understand your risk tolerance level. Irrespective of the time horizon or the duration of stock, only diversify on stocks you can comfortably work with their risk. This would help you in a way that even if you have a more risk-averse portfolio, you would be able to balance this with some fixed-income investment. Risk tolerance helps you to balance all aggressive asset allocation model with a fixed income to help reduce the overall volatility of your portfolio.

Also, the time horizon is constantly changing. For instance, assuming you have a stock of 25 years' time horizon and your retirement is in 10 years' time. You may want to change your asset to other investments platform like money market funds or bond which might take a shorter time horizon. This does not only help with shortening the time, but it would also help you with an extreme market swing.

However, it is advisable that once you are closed to your retirements, a substantial portion of your retirement should be in a lower risk investment portfolio with good cash out. Your biggest risk at this point in your life is living out your asset. Also, just as it is advisable to never be 100% invested in stock, do not also be 100% allocated to short-term investment if your time horizon is greater than one. This is because even in retirement you would need some level of exposure to growth-oriented programs in order to ensure your asset stays longer than even a decade after your retirement.

How Many Stocks Can You Own As An Investor?

While it is generally advisable that you should diversify, there would be a point when adding more stock to your portfolio would cease to make a difference. Hence the question, how many stocks should an investor invest while trying to reduce risk to the barest minimum and at the same time maintain a high return?

The commonest answer to this is that an investor can achieve optimal diversification with not more than 15-20 stocks spread across various industries.

Summary

Diversification is one of the very effective ways investors can manage risk and reduce the volatility of the price of assets. However, diversification alone cannot control all risks. While diversification can be used to reduce diversifiable risk, it cannot be used to avoid general market risk. Market risk affects all stocks in the market. But while diversification helps to control individual risk, this would inadvertently reduce the effect of market risk on the stock. The basic key is to find a balance between risk and return. This would help you achieve your financial goal.