What is diversification?
Diversification is an investment strategy that aims to spread risk across multiple asset classes, geographies, currencies, maturities, and more. The goal is to build a portfolio of investments that will react differently to the same changes in the market. This article aims to show the value of diversification and how you can incorporate it into your investing strategy.
Why investors need diversification
Before we explore more about what diversification is, it’s important to understand why it’s such a necessary tool for investing.
Any investment is subject to some level of risk. There are two main types of risk that affect investments: systematic risk (also known as market risk), and unsystematic risk. Systematic risks are those which affect an entire market, for example – political factors, recessions, pandemics, and fluctuating interest or exchange rates. Unsystematic risk relates to risks faced by individual companies, such as new competitors entering the market, business continuity, and compliance or financial issues.
The most common financial risk relates to a company’s cash flow and its ability to meet its financial obligations. In terms of loans, an example would be if the borrower could no longer make the loan repayments. The money you invested in that loan would be at risk.
While diversification is an effective way of reducing unsystematic risk, systematic risk is generally unavoidable since it’s brought on by existing economic conditions and is outside the control of businesses.
So, how does diversification work?
A diversified investment portfolio makes sure no single investment is responsible for the portfolio’s performance. This strategy aims to have the higher-performing investments outweigh the lower performing investments, so even if some make a loss, you are more likely to average out an overall profit from the remaining investments.
For example, if you were to invest 100% of your money in volatile stocks, the level of risk would be quite high, but the expected returns could also be high. However, let’s say you decided to change your portfolio so that it consisted of 50% stocks and 50% bonds. Bonds are typically lower in risk than volatile stocks, but also lower in terms of expected returns. By adding in a lower-risk, asset class such as bonds, the overall risk of your portfolio has now been reduced. This is because the risk and return variables of the stocks (high risk, high return) and bonds (low risk, low return) average out when you consider the overall success of the portfolio as a whole. In other words, the portfolio with both stocks and bonds has lower risk compared to a portfolio made up of just volatile stocks, and a greater chance of earning profitable returns overall. This is the basic principle of diversification.
Risk exposure can never be completely eliminated, but it can be reduced, and diversification provides investors with a way to do this. The more diversified your portfolio is, the more the overall risk is reduced with expected returns. Because diversified investments behave differently from each other, the portfolio as a whole becomes less affected by external global events and market turbulence.
Creating a strategy for diversification
There is no one-size-fits-all approach to creating a diversification strategy because it can be achieved in a variety of different ways. However, a general guideline is to choose investments with different variables, such as different asset classes, geographies, currencies, and maturities.
Diversification across asset classes
An investment portfolio can be diversified by investing in more than one asset class. An asset class represents a group of investments with similar characteristics. Some examples of asset classes are:
- Real estate
- Alternative asset classes such as loans
Each asset class is subject to different factors that determine whether they perform well as investments, such as liquidity, volatility in the market, stability of returns, and inflation. By including more than one asset class in an investment portfolio, the risks of external events affecting your whole portfolio at the same time are reduced. For instance, if there were a drop in demand for cars, it would likely affect the stocks of car companies but less likely to affect uncorrelated assets such as real estate.
An example of the differences between asset classes
Diversification across geographies and currencies
Investments that are part of the same asset class can be diversified by geography and currency. Countries have different characteristics (both good and bad), and each has an economy influenced by its own decisions. Political instability, economic crashes, and pandemics are just a few factors that can pose risks to the outcome of an investment.
By incorporating geographical diversification into an investment portfolio, you reduce overall exposure to these country-specific risks. With currency diversification, you reduce the risks associated with exchange rates having an effect on your entire portfolio at the same time. Furthermore, by having investments in more than one country, you increase the opportunity for more returns, as multiple countries may provide good returns at the same time. Within the loans asset class, for example, Mintos investors can diversify their portfolios by investing in loans issued by lending companies from different countries with multiple currencies, decreasing their overall exposure to country and currency risk but increasing their exposure to returns.
Diversification across maturities
The length of time investors are willing to commit to investments is also important, as the risks and returns associated with short-term and long-term investments may be different. Therefore to help spread these risks, an investment portfolio can also be diversified by having a range of different maturities.
Short-term investments are often characterized as being riskier but can provide higher returns. This is because they aren’t around for long enough to wait out any correction in the market if there’s a significant spike or drop. Longer-term investments (such as real estate), typically provide slower, steadier returns because they are less affected by sharp changes in the market. So while it can be beneficial to have a range of maturities within a portfolio, a long-term approach to investing overall will ensure you can meet your investment goals with lower risk.
The importance of your risk appetite
Diversification aims to reduce overall risk, but as every investor has different risk and return expectations, there isn’t just one way to diversify a portfolio. So there are different ways for investors to achieve diversification based on their risk appetite. At Mintos for example, investors can diversify with a conservative, moderate, or high-yield investment approach using premade strategies, depending on what their goals are. For instance, an investor with a higher risk appetite can diversify while focusing on loans with high returns and still have a more favorable outcome than having not diversified at all.
Diversification means less overall risk
Expected returns are the motivation behind investment decisions, but the risks associated with investing are why diversification is important. Regardless of your risk appetite, by having a diversified portfolio with different variables, you can reduce overall risk and increase the chances of achieving your expected returns.
If you’d like to know more about diversification on Mintos, check out our article on how to create a diversified portfolio.