The Importance of Diversification
The recent COVID-19 pandemic, geopolitical turmoil, and high inflation have brought about unsettling investment market volatility. When a market is volatile, it is even more important to have a diversified investment portfolio. Diversification helps your portfolio withstand volatility and smooth returns over time.
So, what is diversification, and why is it so important?
What is Diversification?
Diversification is the investment equivalent of not putting all your eggs in one basket and is a core principle of portfolio management.
You can achieve diversification by simultaneously investing in different asset classes such as stock market equities, bonds, cash, real estate, private equities, and other alternative investments. Within an equity portfolio, you can diversify by investing in different industry sectors as well as different-sized companies (i.e. large-cap, mid-cap, and small-cap).
The benefit of diversification is to help you achieve your goals with as little stress as possible along the way.
The Importance of Diversification
Diversification is your most important strategy for reaching your long-term investment goals while minimizing long-term risk.
Because risk/return factors vary across asset classes and sectors, investments perform differently relative to market environments.
In many cases, different asset classes act differently under the same market conditions. For example, if interest rates increase, bond prices go down, but many stocks will increase in value if the economy remains strong.
As more holdings across different sectors and asset classes are added to your portfolio, overall portfolio risk will decline. As the number of holdings increases, your maximum benefit is reached where there is no appreciable risk reduction with the addition of another holding. Academic studies have suggested that the benefit of diversification may be maximized with as few as 20 to 30 holdings.
By spreading your investments across different types of companies you are less likely to realize a significant loss due to a single holding or sector downturn.
It is impossible to remove all the risk exposure in your portfolio, but you can reduce your risk exposure through efficient diversification.
Diversification in an Evolving Market
Common strategies you can use during periods of high inflation are to increase your cash allocation, and allocate a greater proportion of your equity investments to dividend-paying stocks.
Systematic rebalancing, the practice of trimming exposure to portfolio holdings that have outperformed and adding to those that have underperformed, can help maintain optimal diversification in line with your specific goals, investment horizon and risk tolerance. By following this strategy, you are effectively “buying low and selling high” as you rebalance your portfolio to your long-term targets.
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This content is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this content should consult with his or her financial partner or advisor.