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Diversification: Introduction & Types & Strategies

What is Diversification?

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Diversification is the process of allocating capital in a way that lessens the exposure to any one specific asset or risk. A common path towards diversification is to lessen risk or volatility by investing in a variety of assets.

Diversification makes sure that an investor’s portfolio doesn’t lean too heavily on one type of investment. That means investing in a variety of asset classes, such as stock as well as material assets like real estate, or government bonds.

This article will explore different asset classes and funds you can consider when devising a diversified portfolio.

See also: 11 Portfolio Management Tips on How to Diversify Your Assets

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Diversification with Domestic Stocks

Stocks can fill one of the more growth-oriented pockets of your portfolio. A stock can grow as much as the firm that matters it does. Think of the largest multi-billion dollar companies that are now household names. Historically, equities (stocks) have generated a higher rate of return than most other asset classes. However, with the potential for substantial development comes a greater degree of risk. That’s why most financial advisors suggested that you carefully invest in stocks based on your own risk tolerance and time horizon.

Those who have a high risk appetite and can invest longer might be more comfortable devoting big sections of their portfolio to equities. The rationale here is that you have more time to recover from market swings and reap the gains.

See also: Things to remember when picking stocks

Diversification with Bonds

Most investors view bonds as safer, low-risk securities. When you buy a bond, you’re loaning money to a corporation, government or other entity. As a result, the entity approves to pay your money back plus interest.

These investments tend to pay interest on a periodic basis. But historically, they have delivered lesser returns than equities. Still, investors who are more focused on preserving their money than growth tend to favor these fixed-income securities. U.S. treasury bonds, for example, are generally considered quality bonds. But just like there are apparently endless firm stocks you can invest in, you also have some bond options. These include municipal bonds, savings bonds and baskets of bonds (more on that later).

See also: 5 of the Best Types of Bonds You Should Know in 2018

Diversification with Short-Term Investment

Most investors also put short-term securities in the class of low-risk investments. These include short-term certificate of deposit (CD) accounts with fixed interest rates. You can open a CD at most banks for terms extending from just a week to five years. Moreover, CDs tend to pay better interest rates than even the best savings accounts. You can always shop around for the best CD rates. Just ensure you don’t touch the money until your term ends or you’ll face a hefty early-withdrawal penalty. On the other hand, money market accounts typically offer easier access to your funds. However, the safety provided by such investments also means they don’t usually generate high returns compared to stocks or bonds. But they deserve room in your portfolio if your objective is preservation of capital.

Diversification with Real Estate Funds

Regardless of how much interest you generate from a specific investment, a high level of inflation can reduce the worth of your return. Inflation-protected securities aim to hedge against this risk. These investments tend to perform well in periods of high inflation. One example is real estate. And one of the easiest ways to invest in this asset class is through publicly-traded real estate investment trusts (REITs). You can purchase shares of these as you would with a stock. You can also diversify your portfolio with other inflation-protected securities like commodities or funds that invest in commodity-reliant industries like oil, gas and mining.

See also: Real Estate Investing for Beginners

Diversification with Mutual Funds

If you’re not too sure about hand-picking stocks and bonds for your own portfolio, you can always invest in already diversified mutual funds. Professional fund managers make these portfolios with a mix of stocks, bonds or both. Some also offer exposure to asset classes like real estate or particular sectors of the economy such as the healthcare industry. Some mutual funds also diversify their holdings with securities from different countries and emerging markets. But because they pool investors’ money, it’s easier to buy shares of a mutual fund than making one yourself.

Mutual funds involve a lot of moving parts. That’s why it’s significant to shop around for one with an asset allocation that meets your risk tolerance and time horizon.

See also: Mutual Funds 101: Types and Risk (Part 1)

Diversification with Index Funds

Index funds aim for diversification by investing in securities found in a specific index such as the S&P 500. This specific index captures the market capitalization or value of the country’s 500 biggest firms. An index fund aims to reflect the performance of its corresponding index. As a form of passive investing, index funds require little management as opposite to their active counterparts which try to outperform the index rather than mirroring it. In turn, that generally means lower fees for the investor. You have some types of index funds to choose from. Some track indices that focus on big corporations, while others aim for smaller companies. Others track particular industries.

Diversification with ETFs

Exchange traded funds (ETFs) function very similarly to index funds. The main difference is that an ETF can be traded throughout the day like a stock. On the other hand, shares of an index fund (a type of mutual fund) can merely be purchased and sold at day’s end at its Net Asset Value (NAV).

Other than that, ETFs track indices and usually aim to reflect the performance of those. These types of investments enable you to diversify your investments by providing easy access to markets such as commodities.

Diversification with TDFs

Target-date funds (TDFs) are mutual funds that automatically change their asset allocation based on the investor’s age. Generally, they aim to invest more heavily in growth-oriented securities like stocks when the investor is young. They then switch gears toward fixed-income and other “safer” securities as the investor ages.

That’s one of the reasons why most 401(k) plan menus include TDFs. All you have to do is select one named after the year closest to the one once you expect to retire and the fund manager does the diversification for you. But no TDFs are alike. In fact, two TDFs named after the same year but managed by two different firms can have drastically different asset allocations and objectives. You should choose one that most closely reflects your time horizon and risk tolerance.

See also: Asset Allocation: How Much Should You Invest in Stocks and Bonds?

Diversification Strategies

Diversification Strategy blue key.

Diversification strategies are used to extend the firm’s product lines and operate in several different markets. It helps to increase flexibility and maintain profit in slow financial periods.

Concentric Diversification

A concentric diversification strategy lets a company to add similar products to an already established business. For example, when a computer business making personal computers using towers starts to produce laptops, it uses concentric strategies. The technical knowledge for new venture comes from its present field of skilled employees.

Concentric diversification strategies are rampant in the food production industry. For example, a ketchup producer starts producing salsa, using its present production facilities.

Horizontal Diversification

Horizontal diversification enables a company to start discovering other zones in terms of product manufacturing. Corporations rely on present market share of loyal customers in this strategy. When a television producer starts making refrigerators, freezers and washers or dryers, it uses horizontal diversification.

A disadvantage is the corporation’s dependence on one group of customers. The corporation has to leverage on the brand loyalty associated with present products. This is risky since new products may not gather the same favor as the corporation’s other products.

Conglomerate Diversification

In conglomerate diversification strategies, firms will look to enter a previously untapped market. This is often done using mergers and acquisitions.

Moving into a new business is highly risky, because of unfamiliarity with the new business. Brand loyalty may also be reduced when quality is not managed. Nonetheless, this strategy offers increasing flexibility in reaching new financial markets.

For example, a firm into automotive repair parts may enter the toy manufacture business. Each firm enables for a wider base of consumers. There is an opportunity of income when one industry’s sales falter.

Vertical Diversification

Vertical diversification happens once an organization goes back to preceding stages of its production cycle (backward integration) or moves forward to following stages of the same cycle (forward integration). This means that the organization goes into production of raw materials, distribution of its products, or further processing of the present end product.

Corporate Diversification

Corporate diversification involves production of unrelated but certainly profitable goods. It is often tied to large investments where there may also be high returns.

Internal Diversification

One form of internal diversification is to market current products in new markets. An organization may elect to widen its geographic base to include new consumers. The organization can also pursue an internal diversification strategy by finding new users for its existing product.

External Diversification

External diversification happens once an organization looks outside of its current operations and purchases access to new products or markets. Mergers are one common form of external diversification. Mergers happen when two or more organizations combine operations. These organizations are usually of similar size. One goal of a merger is to achieve management synergy by making a stronger management team. This can be achieved in a merger by combining the management teams from the merged firms.

Rationale for Diversification

There are two dimensions of rationale for diversification. The first one relates to the nature of the strategic objective: Diversification may be defensive or offensive.

Defensive reasons might be spreading the risk of market contraction, or being forced to diversify once existing product or existing market orientation seems to provide no further opportunities for development. Offensive reasons may be conquering new positions, taking chances that promise greater profitability than expansion opportunities, or using retained cash that exceeds total expansion needs.

The second dimension involves the expected results of diversification: Management may expect great financial value (growth, profitability) or most important great coherence with their present activities (exploitation of know-how, more efficient use of available resources and capacities). In addition, organizations may also discover diversification just to get a valuable comparison between this strategy and expansion.

Final Thought

The risk/return tradeoff refers to an investor’s balancing the lowest feasible risk and the highest feasible return in any investment choice. Higher risk equals greater potential return, but it does not guarantee those returns levels.

Diversification is a tool to lower the risk of a portfolio by spacing investments out across different areas. Asset allocation is a means of dividing assets across major categories, achieving diversification and reducing risk.

See also: Tips for high and low risk investment

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