DEFINITION: The term “diversification” refers to a strategy for managing risk that involves forming a mixture of different types of investments within a portfolio.
This diversified portfolio consists of a variety of unique asset types and investment instruments, the purpose of which is to minimize the investor’s vulnerability stemming from the risk accruing from any particular kind of asset.
The underlying logic behind diversification is that a portfolio made up of different classes of assets will typically generate greater long-term returns, while reducing the risk associated with any single kind of security.
ETYMOLOGY: The English noun “diversification” is formed from the adjective “diverse,” which is attested from the thirteenth century.
“Diverse” derives, via Middle English divers, from Old French divers, meaning “diverse,” which, in turn, derives from the Latin past participle dīversus of the verb dīverto, dīvertere, meaning “to turn in different directions” or “to differ.”
USAGE: Economics research, including mathematical simulations, lends support to the intuitive idea that a properly diversified portfolio—consisting of around 30 different kinds of stocks—provides the optimal balance between cost-effectiveness and risk reduction.
While investing in additional securities always offers some incremental advantage, the effectiveness of the diversification strategy begins to diminish rapidly beyond a certain point.
The goal of diversification is to mitigate the impact of relatively isolated (unsystematic) risk-creating events which may adversely affect a given portfolio. This allows the favorable performance of certain investments to counterbalance the unfavorable performance of others.
However, the advantages of diversification are applicable only when the securities in the portfolio are not too closely correlated. This means they must respond to market forces in different ways, often moving in opposite directions.
Many investment strategies are available for investors who wish to explore options for diversifying their portfolios. These various methods can often be combined to increase a portfolio’s diversification still more.
Diversification, as practiced by fund managers and investors, consists in spreading the investments within a portfolio across different asset classes. The managers and investors must also decide on what percentage of the whole portfolio to allocate to each asset class.
Each type of asset class presents distinct sets of risks and opportunities. These classes may encompass:
- Stocks: Ownership stakes (shares) in private companies or equity in publicly traded companies
- Bonds: Fixed-income debt instruments issued by corporations and governments
- Real estate: Property, including land, buildings, natural resources, agriculture, and livestock, as well as water and mineral deposits
- Exchange-traded funds (ETFs): Tradable groupings of securities, which track an index, a commodity, or an economic sector
- Commodities: Fundamental goods that play a crucial part in the production of other products or services
- Cash and short-term cash-equivalents (CCE): Short-term, low-risk investments, such as money-market instruments, Treasury bills, certificates of deposit (CDs), and similar paper
Theory suggests that factors which could have an adverse effect on one asset class may in fact benefit another class.
For example, increasing interest rates may have a negative impact on bond prices. Why? Because the yields on previously purchased bonds—which are already locked in—will be paid out at the old, lower rate, making bonds as a class a less-attractive investment.
On the other hand, increasing interest rates may have a positive impact on other asset classes, such as real estate—which may generate higher income from rents—or commodities—which are also likely to increase in price.