Diversify & Conquer
Diversification is simply a risk management strategy that includes a vast variety of investments within a portfolio. A diversified portfolio contains a mix of specific asset types and investment vehicles to limit exposure to any single asset. The logic behind this technique is that a portfolio constructed of different kinds of assets will have higher long-term returns and lower the risk of any individual holding. These holdings can be diversified not only across classes but also across markets, foreign or domestic. The idea is that the positive performance of one area of a portfolio will outweigh the negatives of the other.
Market studies indicate that maintaining a well-diversified portfolio of 25 stocks yields the most cost-effective level of risk mitigation. Diversification in essence strives to smooth out unsystematic risk events in a portfolio, thus the positive performance of some investments neutralizes the negative performance of others assuming not perfect correlation. Optimal portfolio management has to diversify investments across asset classes and determine what percentages to allocate to each.
We need to be aware of the different categories of assets. Stocks are shares or equity in a publicly-traded company. Bonds are government and corporate fixed-income debt instruments. Real estate is land, buildings, natural resources, agriculture, livestock, and water and mineral deposits. Exchange-traded funds are a marketable basket of securities that follow an index, commodity, or sector. Commodities are basic goods necessary for the production of other products or services. Cash and short-term cash-equivalents are Treasury bills, certificate of deposit, money market vehicles and other short-term, low-risk investments. All these and others could split into different sectors or different market capitalizations.
However, there are some drawbacks also. The more holdings a portfolio has, the more time-consuming and expensive it can be to manage, since buying and selling many different holdings incurs more transaction fees and brokerage commissions. Furthermore, diversification's spreading-out strategy works both ways, lessening both the risk and the reward. Time and budget constraints can render it difficult for private investors to create an adequately diversified portfolio. This challenge is a key reason why mutual funds are so popular with retail investors. Mutual funds offer for decades an inexpensive way to diversify investments. Ultimately, the new trend exchange-traded funds (ETFs), provide with investor access to narrow markets that would ordinarily be difficult to enter.