Updated: June 15, 2020
Diversification is an advice that many financial planners give when it comes to building your investment portfolio.
This investing strategy is often said through the famous saying, “Don’t put all your eggs in one basket.”
The idea behind diversifying your assets or investments is that, markets are unpredictable.
And by putting your money in different instruments, then you can hedge against losses because as the value of one asset goes down, others could go up.
Just look at the graph below of the Philippines Government 10-Year Bond Yield (blue) versus the Philippine Stock Market Composite Index (green) from 2010-2020.
Inside the first, red box, you’ll see that as the bond yield was going down, the stock market index was going up.
If you were invested in both bonds and stocks during this time, then the total value of your portfolio would probably be higher than someone who only have bond investments.
And there’s a similar truth inside the second, orange box, where the bond yield and stock index moved in opposite directions.
Advantages and Disadvantages of Diversification
The biggest benefits of diversification is that it reduces portfolio risk, it hedges against market volatility, and historically, it gives higher returns in the long-term.
Meanwhile, on the other side of the coin, having a diversified portfolio limits your short-term gains. It can also be time-consuming to manage because you’re looking at different types of assets, which could also mean you’ll be paying more transaction fees to different brokers and institutions.
Personally, I think that diversification is good, especially for long-term investors and for individuals who don’t have time to watch the markets regularly.
Different Ways To Diversify
So how do you do diversification? Based from the questions that I regularly receive, there’s always confusion as to how exactly do you diversify your investments.
Is it just a matter of investing in many different instruments? Well, that’s correct. Diversification simply means investing in different instruments.
However, what many fail to do is to define or choose the parameter at which they’ll differ. Below are the five most common parameters.
1. ASSET CLASS
The most common way to diversify. Different assets perform differently in various economic conditions.
Just like our graph above, you’ll see that stocks and bonds don’t necessarily move in the same direction. The same can be said for real estate, commodities, currencies, and other asset classes.
2. SECTOR / INDUSTRY
You can also diversify in terms of sectors or industries, especially if you’re investing on individual stocks.
It would be risky to just buy consumer stocks such as food and retail companies. You can perhaps, also invest in companies in the finance sector, real estate industry, the energy sector, etc.
3. SIZE / CAPITALIZATION
It’s common for people to only buy large-cap or blue chip companies. There’s nothing wrong with doing this, but know that they’re prices don’t normally move as much as medium-sized businesses and second-liners in the stock market.
This also applies to investment funds. You can diversify by acquiring units or shares of funds of different sizes. The large ones for stability, and the smaller ones for the agility.
4. FEATURE / TYPE
Investments have three main features — liquidity, growth, and income. The stock market offers growth and liquidity, but it’s not a good source of regular income. Real estate properties can give you growth and income, but it’s not a liquid investment.
Diversification under this parameter means consider having different investments that offer you a variety of features, depending on your needs and financial goals.
5. COUNTRY / LOCATION
Lastly, you invest in other countries and earn from the growth of other economies. For example, I have money in forex, cryptocurrencies, indices, and also own U.S. stocks, which I invest through eToro.
How much you should invest largely depends on the growth potential because in doing this, you’re also exposing yourself to foreign exchange risk. But, this is something you can definitely manage with proper financial planning.
It’s always good for long-term investors to diversify. You can use different parameters, as stated above, to come up with a good portfolio mix that can help you achieve your financial goals with less risk.
A truly diversified portfolio would look into instruments that have low or negative correlations, so that if one moves down then there will be another that counteracts it and moves up.
The simplest way to diversify, especially for new investors, is to invest in Exchange Traded Funds, Unit Investment Trust Funds, and mutual funds. But just be aware of the hidden costs and admin fees that these carry.
Lastly, it would greatly help if you can study and understand how markets and economies behave, because this will allow you to better manage and rebalance your portfolio through the years.
Do you want to learn more about how to diversify your investment portfolio? Then comment your questions and suggestions down below and I’ll write a follow-up article to answer them.
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