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Diversification Strategy

With the financial markets all the time bouncing up and down, investors have a great need for safety. One of the most popular ways which can prevent the entire portfolio from losing value is the diversification strategy, a term which is well known among investors, traders, analysts and portfolio managers.

What is Diversification Strategy?

Diversification in its most general sense is the risk reduction in portfolio through smart asset allocation. The well known phrase which always comes with this term is “Don’t put all your eggs in one basket”. Though the latter theoretically covers the main message of diversification, it does not provide practical implication of what role the diversification plays in portfolio investment and how to create a diversified portfolio.

Portfolio diversification is a risk management technique whose main objective is to mix wide range of investments within a portfolio. The rationale on which this technique is based asserts that a portfolio consisting of different kinds of investments will bring higher returns and face lower risk than any single investment in the portfolio.

Allocating assets smartly lowers unsystematic risk in a portfolio so that the positive performance of some investments will neutralize the negative performance of others and keep balance. Therefore, diversifying through unrelated assets which are not closely correlated will be more beneficial.

How to Develop an Optimal Diversification Strategy

To ensure that you have a well diversified portfolio you should take into account certain things while creating your portfolio.

  • The portfolio should include different assets, like stocks, currencies, commodities and indices.
  • Assets should vary in risk level. Selecting various investments with different rates of return will ensure that large returns in one area can balance losses in other areas.
  • Assets should vary by industry. Stocks within the same industry tend to rise and fall as a group since the same underlying factors exist for all members. Once the investment is made by allocating to different industries, it will minimize the unsystematic risk to small groups of companies.
  • The quantity of assets should not be considered as important as the allocation of assets with different weights across various industries. Though MPT suggests that after 10-12 diversified assets one is very close to optimal diversification, it doesn’t mean that buying 12 tech stocks will help to obtain it.

While most investment professionals accept that diversification strategy does not completely guarantee against losses they meanwhile accept it as the most essential component in reaching long-range investment goals with minimal risk exposure.