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What is Diversification?

| March 26, 2019
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Diversification is one of the most important tools in the investor’s tool belt. It prevents those investors from putting all of their eggs into one basket.

It could also help minimize the odds of your whole portfolio losing value at the same time, though that has happened.

In this article, we’ll explore what diversification is, what it applies to, and how you can use it.

What is diversification?

Diversification is an investment practice that is used to enhance return and mitigate risk by utilizing a number of different asset classes in a portfolio.

The theory is that by investing in different types of assets, specifically, assets that aren’t correlated with one another, when one type of asset performs negatively, there will be a different asset that performs positively.

Asset classes

There are a variety of different asset classes that can be used when diversifying your portfolio.  Some examples include:

  • Stocks
  • Bonds
  • Real estate
  • Precious metals
  • Cash

Geography

It’s not enough to diversify by asset class, you should also diversify by geographic location as well. This is important because not all countries are going to do well at the same time.

The United States stock market makes up almost 40% of the total global market. If you invest only in the U.S., you are excluding over half of the total market which could negatively affect your returns.

Sectors

There are many different sectors in which you can invest in. Some sectors perform really well when the market is hot, others hold up a little better when the market declines.

Investing in a variety of sectors could give you the ability to weather down markets, but also be able to participate in up markets.

If you’d like to learn more about sectors, click here.

Correlation

The relationship between two asset classes/types. Described as a number between +1 and -1.

A correlation of +1.0 means that the two assets move exactly the same in direction and speed. When one goes up 10% the other goes up 10%

A correlation of -1.0 means that the two assets move exactly at the same speed, but in totally opposite directions. When one goes up 10%, the other goes down 10%.

Any variation in between will change the speed of the move. Correlations can change in time, however. Here are a few examples.

  • Correlation between stocks and bonds for May 2018 was -.07
  • Correlation between stocks and gold ranges between +.75 and -.07
  • Correlation between bonds and gold ranges between +.39 and -.07

Combining different asset types with varying correlations can be an effective way to diversify your portfolio. That way you aren’t capturing all of a downside. The tradeoff is you won’t capture all of the upside either.

Beta

Beta is similar to correlation in that it indicates which direction a security moves and at what velocity, usually compared to a benchmark. The general guidelines for this are the same as correlation, +1.0 to - 1.0. However, those aren’t the limits.

A security can go passed +1.0 and passed -1.0. Here are a few examples.

  • The beta of a technology sector ETF is 1.07
  • The beta of a consumer staples sector ETF is .64
  • The beta of a gold ETF is -.24

When diversifying your portfolio, it’s a good idea to use securities/funds with varying levels of beta.

Conclusion

Diversification plays into your emotions, as studies show we experience the pain of a loss two times stronger than we experience the joy of a gain. It is wise, from a psychological perspective, to do what you can to try and ease that pain.  Diversification seeks to reduce the volatility of a portfolio by investing in a variety of asset classes but it does not guarantee a profit or protection from losses in a declining market.

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