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Diversification of Assets

Asset diversification is a risk management strategy. It involves investing in a combination of assets which, due to their divergent nature, carry different types and levels of risks.

An investor who practices asset diversification invests not only in diversified asset categories but also in diversified industries within an asset category. Diversifying asset categories and industries within asset categories spreads the risks of certain risky assets more evenly throughout a portfolio.

The Importance of Asset Diversification

Why do most coffee shops have both hot and cold drinks in their menu? Coffee is supposed to be hot, why the cold drinks? The fact is that these coffee shops' owners are hedging against the days when it will be too hot and the demand for hot coffee will be less. When winter comes, the cold drinks will no longer be in demand, but they'll still have revenue from the hot drinks they sell.  By having both in the menu, the coffee shop can minimize their losses regardless of what the weather is.

The principle of diversification works pretty much the same way. Different asset classes perform differently when exposed to certain market forces. In a bull market for example, the prices of stocks and real estate may skyrocket while the prices of bonds may remain relatively the same. Conversely, in a bear market where there is scarcity of capital, bondholders may actually earn greater returns than stockholders.

Asset diversification, therefore, is an important balancing strategy. It helps investors safeguard their investment from damaging market forces. An investor who doesn't have all of his eggs in one basket can protect his investment and avoid losing everything he has worked so hard for on a single downturn shift in the market.

Asset Diversification versus Narrow Investing

Asset diversification entails combining different assets with different rates of return and different levels and types of risks into one portfolio. Narrow investing, on the other hand, entails investing heavily in a specific asset category.

If asset diversification is a risk management strategy, narrow investing is a profit-maximizing strategy. A portfolio consisting mainly of stocks, for instance, should have an excellent rate of return. Stocks, as a general rule, provide the highest possible rates of investment returns.

Of course, such a portfolio also comes with great risks; stocks, after all, are also the riskiest asset category. Such risks are further magnified by the narrow investing focus. If the stock market crashes, the owner of the portfolio will lose all of his investments.

In contrast, someone who has a more diversified portfolio will also sustain some damage in a stock market crash, but the assets in his portfolio that were less susceptible to the crash will be able to take up the slack and keep him afloat.

Ultimately, choosing between asset diversification and narrow investing boils down to prioritizing your investment preferences. If you want to manage your risks more than you want to maximize your returns, you will diversify. If you want to maximize your returns more than you want to manage your risks, you will invest narrowly.

Issues with Asset Diversification

It should be emphasized that asset diversification is not primarily a strategy for maximizing the returns on your money. While it does this to some extent, diversification is a strategy used mainly to minimize risks and losses.

Thus, asset diversification can reduce your investment returns. Money that you could have used to invest on high-yield instruments are instead invested in lower-yield products. For this reason, some people believe that diversified portfolios will always perform below the optimum level.

Asset Diversification Strategies

As with asset allocation strategies, there are also different ways in which investors can reduce risks through asset diversification. The following are some of the most common diversification strategies used:

  • Diversification among Asset Categories

    The most common diversification strategy, spreading your investment among different asset categories reduces the risk of investing because different asset categories such as real estate, stocks, bonds, funds, treasury notes, etc. react differently to negative market downturns.

  • Diversification within Asset Categories

    Different industries also react differently to market shifts. Therefore, you can spread your risks by investing in unrelated industries. The efficacy of this strategy was demonstrated when internet technology stocks were not as hard hit by the recent economic crisis as other types of stocks, particularly those issued by financial and automobile companies.

  • Diversification of Risks

    You can also spread your investments among high-risk, medium-risk and low-risk investments. This way, you can offset losses in one area by gains made in other investments.

  • Diversification through Geography

    You can also invest in international securities to hedge against domestic market downturns. By spreading your investments among different countries, you can prevent losing your money in a geographically limited crisis.

Diversification and Mutual Funds

Mutual funds are the ultimate investment product of choice for investors who want to manage risks. Mutual funds are invested in a diverse range of assets including stocks, bonds and cash/cash equivalents. By investing in a mutual fund, therefore, you automatically get the benefits of diversification.

Note, however that some mutual funds are very industry- or category-specific. You may have to invest in several mutual funds before you can achieve your desired level of diversification.

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