Diversification is an investment strategy aimed at reducing risk by spreading investments across a variety of assets or asset classes. The idea behind diversification is simple: "Don't put all your eggs in one basket." By holding a mix of different assets, investors can potentially reduce the impact of negative events on their overall portfolio and increase the likelihood of achieving more stable returns over time.
The key principles of diversification are as follows:
- Asset Allocation: Diversification involves investing in different asset classes, such as stocks, bonds, cash, real estate, and commodities. Each asset class has unique risk and return characteristics, so spreading investments across them can help balance the overall portfolio's risk.
- Within Asset Class Diversification: Within each asset class, further diversification can be achieved by investing in different individual securities or assets. For example, within the stock portion of a portfolio, an investor can hold stocks of companies from different industries and regions.
- Risk Reduction: Diversification reduces the impact of a single asset's poor performance on the entire portfolio. When one asset performs poorly, gains in other assets may offset the losses, mitigating the overall impact.
- Balancing Risk and Return: While diversification can lower risk, it may also impact potential returns. Some assets may offer higher returns but come with higher risk, while others provide stability with lower returns. Finding the right balance that aligns with an investor's risk tolerance and financial goals is crucial.
- Long-Term Strategy: Diversification is most effective when viewed as a long-term investment strategy. It does not guarantee against losses, especially in extreme market conditions, but over time, it can enhance the potential for more consistent and less volatile returns.
Investors can achieve diversification through various means, such as building a diversified portfolio of individual stocks and bonds, investing in mutual funds or exchange-traded funds (ETFs) that offer exposure to multiple assets, or using target-date retirement funds that automatically adjust their asset allocation based on the investor's time horizon.
Because diversification of an investment portfolio, it's one of the key measures we show you on the dashboard. When looking at your Overview, you'll be presented with a Strabo Diversification Score (SDS), alongside some suggestions on how to rebalance your portfolio to keep in line with your investment objectives, as well as your appetite and tolerance for risk.
It's important to note that while diversification can reduce risk, it does not eliminate it entirely. No investment is entirely risk-free, and all investments carry some level of risk. However, diversification remains a fundamental strategy to manage risk and potentially improve the overall performance of an investment portfolio. You can read more about diversification in our long form guide here.