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26 Nov 2020

Why Diversification Matters

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What is portfolio?

Before we understand the meaning and importance of diversification, let us take a look at what is portfolio or what is a portfolio in finance and investment terms and what is a diversified stock portfolio.

A portfolio is essentially a collection of a wide range of assets owned by investors to generate revenue. These financial assets can range from gold, stocks, derivatives to funds, property, cash equivalents, bonds and others.

What is diversification, and how does it help?

Diversification definition -

If you look at diversification’s definition, it is a risk management strategy that mixes different investment products within a portfolio to yield higher returns and lower the overall risks. Now that we know what is diversification, let us understand how does diversification protect investors.

If you want to mitigate the risk and volatility in your portfolio, diversification is one of the best ways to do so. It helps to spread your investment in a manner such that your exposure to any one type of asset remains limited. Diversification is important in investing because it allows you to balance your comfort level with risk against your time horizon.

One of the most popular forms of diversification in finance is asset allocation. It allows you to incorporate elements of different investment classes in your portfolio and protect it from the loss that can occur due to over-dependence on only one asset category. That brings us to the next question - what is a diversified stock portfolio exactly?

Essentially, a diversified portfolio is one that gets constructed of investment products with different risk levels and yields that helps in lowering the risk and leverage of the overall variability of the portfolio performance.

A diversified portfolio also tries out to level out the impact of unsystematic risk or specific risks. By owning a large number of investments in different industries and companies, the risks associated with them specifically get minimized. That ultimately decreases the volatility of the portfolio, smoothing out the returns of the portfolio as a whole. Diversification is important in investing because of all the above reasons.

Now that we know what is a portfolio in finance, how does diversification protect investors and the necessity of diversification in finance and investing, let us take a more detailed look at the four primary components of a diversified portfolio -

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Domestic stocks -

Stocks provide the opportunity for high growth over the long term but also represent one of the most aggressive portions of your portfolio. Since the scope of better returns is more, the risk associated with it is also significantly high, particularly in the short term. Overall, stocks are good investment options for the long-term.

However, the volatility involved as compared to other assets demands that you determine the right percentage of this investment product in your portfolio considering several factors like your long-term goals, risk appetite etc.

Bonds -

Bonds usually provide regular interest income and generally get considered to be less volatile than stocks. Since they behave differently than stocks, they also can act as a cushion against the unpredictable movements of the stock market. If you are a risk-averse investor, going for government bonds is a good idea because they carry low risks.

However, you also have to be ready to accept lower long-term returns as compared to stocks. Some fixed-income investments, on the other hand, do provide higher yields such as high-yield bonds and international bonds, but they also come with higher risks as compared to your regular bonds.

Short-term investments -

Short-term investments include money-market funds and certificates of deposits that get considered as conservative investments due to their stability and level of safety. If you are someone who is looking to preserve your principal, these short-term investments can be a suitable option for you.

Though money-market funds get usually thought of as safer or more conservative, they are not insured or guaranteed like a certificate of deposit. On the other hand, while CDs offer more safety, they cannot provide the liquidity provided by money-market bonds.

International stocks -

As an investor, if you are comfortable with investments that offer both higher potential returns and higher risks, you can consider adding foreign stocks to your portfolio.

How diversification can help reduce the impact of the market volatility -

As we have ascertained before, the primary goal of diversification is to reduce the impact of volatility on a portfolio. One of the most common ways of doing so is to add more fixed-income investments to a portfolio.

Even though it can reduce your expectations for long-term returns, it can significantly reduce the effect of market volatility on your portfolio. Another point to remember is that there are several ways by which you can diversify your portfolio. The primary step is to evaluate your long-term financial goals and assess your risk-return expectations.

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This publication is provided for general information purposes only and is not intended to cover every aspect of the topics with which it deals. It is not intended be advice. You must obtain professional advice before taking, or refraining from, any action on the basis of the content in this publication. The information in this publication does not constitute legal, tax, investment or other professional advice from North Loop or its affiliates. We make no representations, warranties or guarantees, whether express or implied, that the content in the publication is accurate, complete or up to date. All opinions expressed do not reflect the views of North Loop nor are endorsed by North Loop.