What Is Diversification?
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- Diversification is about putting money in different assets to reduce the risk of investing.
- While there is no “magic number” of diversification, a healthy mix should preferably contain stocks, bonds, and short-term investments.
- Although it is perhaps the least convenient of the various asset classes in terms of liquidation, real estate can cancel out the risk other investments present because it appreciates over time, which can even outpace inflation.
- Over-diversification can cause a portfolio to underperform since its negative impact on gains may exceed the investor’s efforts to manage risk.
The Goal of Diversification
The goal of diversification is to reduce the risk of an investment portfolio. When an investor diversifies, they are putting money to work in different companies, industries, sectors, asset classes, and/or locations.
In other words, by spreading investments across a wide range of different and separate assets, the investor hopes that even if one investment fails, the others may help offset its non-performance.
In theory, investing in a healthy mix of assets can protect one’s investments, even life savings, when the market turns for the worse. This hinges on the fact that different investment vehicles have varying degrees of risk and reward, and each may react to market volatility differently.
Therefore, a diversified portfolio is an investor hedging against future market forces and their still unquantified effects.
What Is a Diversified Portfolio?
A diversified portfolio broadly refers to an investment portfolio with a mixture of asset classes. A well-diversified portfolio should look something like this:
- 40% bonds
- 35% U.S. stocks
- 15% foreign stocks
- 10% short-term investments
The example above does not always apply to everyone. All investors have different levels of risk tolerance, preferences, and time horizons.
Also, some financial products are either too complex for beginners to understand or inaccessible to investors without deep pockets.
Regardless of the investor’s capital, age, experience, and expertise, what matters is picking uncorrelated assets—for example, investing in natural resources as well as the stock market. This way, some investments may stay or become more valuable even when others plummet.
Investing in Real Estate to Diversify
Real estate can be both a good investment and a good way to increase portfolio diversification. In addition, real estate investments are broad enough that an investor can have holdings in different types of real estate and still have a degree of diversification.
For instance, one of the most common ways to invest in real estate is to rent out a property to tenants. This investment generates regular cash flow and affords the investor or the landlord some tax deductions due to their ability to supply housing. As the local economy grows, so does the recurring income it can bring to its owner.
Second, an investor can buy and hold real estate and allow it to appreciate over time. This passively builds equity and increases its owner’s net worth, especially since real estate appreciation can keep up with, or even outpace, inflation.
Another way to invest in real estate without actually owning property is a REIT, or a real estate investment trust. In terms of diversification, a REIT investment fulfills the role of a stock investment because REIT shares are publicly traded.
Finally, land investing is a special niche of real estate, where investors flip or hold vacant land so it can be developed later on. Land has all the strengths of real estate investing with little of its weaknesses, especially because of its finite quantity. All these potentially make vacant land investing a more solid hedge against market downturns.
How Does Real Estate Diversify a Portfolio?
Real estate works as a diversification strategy because owning real property, which generally appreciates, can protect the investor’s purchasing power as the price of goods and services rises.
More importantly, the performance of another market sector usually has little to no effect on real estate. This means merely owning a house (which contributes to net worth) can keep one’s portfolio from dropping in value when other asset classes are down.
Also, an investor can use real estate equity (such as in a home) to borrow capital and use that capital as leverage to acquire more investments, real estate or otherwise.
That said, some of the strengths of real estate can also backfire. For instance, a rental property sometimes produces negative cash flow when the market’s high vacancy rate is high.
Furthermore, real estate is typically illiquid, so cashing out is more difficult than with some of the more liquid alternative investments.
Is Diversification Good or Bad?
In general terms, diversification is good because it helps mitigate risk no matter what happens to the economy.
Diversification is highly beneficial for investors who want to invest in obscure markets without an in-depth understanding of how those markets work. However, diversifying without knowing the principles behind the investment vehicle will result in poor portfolio performance over the long term, especially if the investment was made emotionally or impulsively.
Additionally, diversification only reduces risk in normal market conditions and cannot prevent losses during major downturns.
Investment risk exists no matter what the asset allocation, meaning even the most diversified portfolio may have to weather some market declines. However, the overall portfolio risk decreases considerably with the right amount of asset class diversification.
Is There a Risk of Over-Diversification in Investing?
Over-diversification in investing is a real risk, as it can diminish the overall average return of the portfolio without driving its risk down. Mutual funds are an example of an investment strategy where diversification benefits are undermined by holding too many positions.
Divided attention is another result of over-diversification. Tracking too many investments will make the investor lose focus on the assets that actually perform.
Ultimately, too much diversification can lead to a wide set of assets beyond one’s ability to manage, defeating the purpose of spreading investments over several asset classes.
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