Diversification Strategies

Diversification is a growth strategy that involves entering a new market or industry, while also creating a new product for that new market. How does this evolve as an investment strategy? In this article, we explore proven Diversification strategies to boost profitability in competitive markets.

What is Diversification?

Diversification is a way to lower your risk by putting together a portfolio of different products. To try to limit exposure to any one asset or risk, a diversified portfolio has a mix of different types of assets and financial vehicles.

This method is based on the idea that a portfolio of different types of assets will, on average, give better long-term returns and lower the risk of any single holding or security.

Studies and math models have shown that the best way to lower your risk for the least amount of money is to keep a diverse portfolio of 25 to 30 stocks. Putting money into more assets does increase the benefits of diversification, but they work much less well over time.

Diversification tries to even out random risk events in a portfolio so that the positive performance of some investments cancels out the negative performance of others. Diversification only works if the securities in the portfolio are not exactly correlated, which means they react to market changes in different, and sometimes opposite, ways.

Diversification Across Platforms

No matter how an investor plans to build their portfolio, maintaining those assets is another aspect of diversification. While this doesn't alter the investment's risk, it presents an additional risk to consider due to its potential for diversification.

Take the case of someone who has $400,000 in U.S. cash. The investor has the same mix of assets in all three of the following scenarios. But their level of risk is different:

• The person can put $200,000 into one bank account and another $500,000. The FDIC will insure both deposits if they are less than the cap for each bank.
• The person can only put $400,000 in one bank account. The protection only covers a part of the deposit. In addition, if that one bank has a bank run, the person might not be able to get cash right away.
• Someone may literally keep $400,000 in cash in their home. Even though the person is easy to get in touch with, their money will not earn any interest or grow. Additionally, the person could lose capital if it is stolen, burned, or lost.

Almost every type of object is related to the idea above. Like, Celsius Network put in for bankruptcy in July 2022.5 Cryptocurrency investors who had funds in the exchange were unable to withdraw or move their money. The chance of loss would have been spread out among many exchanges if investors had spread their money across many platforms.

Diversification Strategies

There are a lot of different strategies that investors can use to diversify their holdings. Many of the strategies below can be used together to make a portfolio more actively diversified.

Industries or Sectors

The functioning of various industries or sectors differs significantly from one another. Spreading their money across multiple businesses reduces the impact of sector-specific risk on investors.

Take the CHIPS and Science Act of 2022 as an example. This law impacts a wide range of businesses, with some experiencing greater impact than others. The financial services industry may experience smaller, longer-lasting effects, while semiconductor makers will be the most affected.

By putting together investments that might balance out different businesses, investors can spread their risk across many industries. Take, as an example, two popular ways to pass the time: travelling and digital viewing. Investors who want to protect themselves against the risk of future big pandemics may want to put their money into digital streaming platforms, which will benefit from more shutdowns.

Additionally, they could consider investing in planes concurrently, which would be a beneficial strategy due to the potential for fewer shutdowns. In theory, these two unrelated businesses may lower the overall risk of the portfolio.

Asset Classes

A lot of the time, investors and fund managers spread their money out among different types of assets and decide what share of the portfolio to put in each one. There are different risks and chances for each type of asset. Some classes are:

• Stocks: These are shares or equity in a publicly traded company
• Commodities: Basic goods that are necessary for the production of other products or services
• Bonds: Government and corporate fixed-income debt instruments
• Exchange-traded funds (ETFs): A marketable basket of securities that follow an index, commodity, or sector
• Real estate: Land, buildings, agriculture, livestock, natural resources, and water and mineral deposits
• Cash and short-term cash-equivalents (CCE): Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments

The idea is that something that hurts one type of assets might help another. For instance, when interest rates go up, bond prices generally go down because the yield has to go up to make fixed-income securities more appealing. On the other hand, higher interest rates could cause prices for goods or rent to go up.

 

Tangibility

We refer to investments in stocks, bonds, and other financial tools as "intangible" due to their intangible nature. Conversely, you can use tangible investments such as land, real estate, farmland, rare metals, or goods in the real world. You can use, rent, develop, or treat these physical assets differently from digital or intangible ones.

There are also risks associated only with tangible objects. Damage to real estate can come from vandalism, theft, natural disasters, or just becoming outdated. There may also be costs for storing, insuring, or protecting real estate. The way money comes in and out of financial instruments is different, and so are the prices of protecting physical assets.

Market Capitalizations

Based on the market capitalization of the asset or business, investors may want to spread their money among different securities. Think about how Apple and Newell Brands Inc. run their businesses in very different ways. Both Apple and Newell Brands were in the S&P 500 in July 2023. Apple made up 7.6% of the market, and Newell Brands made up 0.0065%.

There will be big differences in how each company raises money, brings new goods to market, builds brand recognition, and plans for future growth. Low-cap stocks have more room to grow, but high-cap stocks are usually safer choices.

Physical Locations

Foreign stocks are another way for investors to diversify their portfolios. For example, factors that negatively impact the U.S. economy may not have the same impact on Japan's economy. So, investing in Japanese stocks gives a person a small cushion against losing money when the American economy goes down.

Instead, spreading your money between developed and emerging countries may offer a bigger potential upside, but it also comes with a higher level of risk.

Recently, Pakistan transitioned from being an emerging market player to a frontier market participant. Investors who are ready to take on more risk might want to look at the higher growth potential of smaller markets that aren't fully established yet, like Pakistan.

Growth vs. Value

There are two main types of public stocks: growth stocks and value stocks. Companies projected to make more money or profits than the average in their industry are the focus of growth stocks. Value stocks are shares that appear to be selling at a discount based on the company's current performance.

Growth stocks often carry a higher risk due to the potential for the company's growth to be slower than anticipated. For instance, when the Federal Reserve tightens monetary policy, there is generally less capital available or it costs more to borrow, which makes things harder for growth companies. However, growth companies may have the opportunity to capitalize on seemingly limitless potential and exceed their projected earnings.

Value stocks, on the other hand, tend to be better-known and more stable companies. These businesses may have already reached most of their potential, but they generally come with less risk. By buying shares in both types of businesses, an investor could take advantage of the future potential and current benefits of each.

Risk Profiles

It is possible for investors to pick the basic risk profile of almost any type of asset. Take fixed-income products as an example. A person can buy bonds from either the world's best-rated states or from private companies that are almost bankrupt but need emergency cash. There are big differences between a few 10-year bonds based on the seller, their credit rating, how they plan to run their business in the future, and how much debt they already have.

This also applies to other types of purchases. It's possible that real estate growth projects with more risk will pay off more than properties that are already open for business. On the other hand, cryptocurrencies like Bitcoin that have been around longer and are used more often are less risky than coins or tokens with smaller market caps.

Maturity Lengths

For fixed-income assets like bonds, the risk profiles change depending on the length of the terms. In general, longer terms increase the likelihood that interest rate changes will affect bond prices. Short-term bonds offer lower interest rates and are less susceptible to future yield curve changes. If an investor is willing to take on more risk, they might want to add longer-term loans that pay more interest.

Maturity time is also common in other types of assets. Look at the difference between short-term lease agreements for homes (up to a year) and long-term lease agreements for businesses (sometimes five years or more). By signing a long-term lease, investors are surer of getting rent money, but they give up the freedom to raise prices or switch renters.

Pros And Cons of Diversification Strategies

Conclusion

Diversification is a key idea in both financial planning and managing investments. You put your money into a lot of different things so that the general risk of your portfolio is lower.

You are less likely to lose money if you spread your wealth across several different investments instead of putting all of it into one. Spreading your investments across different types of assets and strategies has become very simple due to the ease of buying, selling, and spending online.

Investors have been discussing diversification strategies extensively for a long time. Investors consider these strategies crucial for long-term growth as they maintain the balance of an investment portfolio's glide path. But, just like any other financial strategy, diversification strategies have pros and cons that people should think about before they use them.