Diversification

What is Diversification?

      Everyone is familiar with the idiom, “Don’t put all your eggs in one basket,” but what meaning does it hold for investors? This piece of advice suggests that one should not devote all of their efforts and resources to a single endeavor, as they risk losing everything. This brings us to diversification!

Diversification is the allocation of a portfolio’s resources or capital to a variety of investments. Diversification’s ultimate objective is to reduce portfolio volatility by offsetting losses in one asset class with gains in another asset class. Similar to the idiom, investors should not invest their entire portfolio in a single asset class, but rather in a variety of assets.

Why is diversification important though? Diversification’s primary purpose is to help eliminate unsystematic risk. Unsystematic risk is a risk that is unique to a single company or a small group of companies and does not affect the market as a whole. As a result, when a portfolio is well-diversified, the positive results from investments that have strong performance compensate for the negative results from investments that have poor performance.

What are Ways to Diversify?

      So then how does an investor make sure they allocate their portfolio so that it is well-diversified? One way is knowing how one asset differs from others, which includes the style, size, location, sector, and class of asset in the portfolio. This is where the table below comes in handy since it explains the various ways in which assets might vary.

Types of Diversifying

Explanation


Asset Style

Investing in the stocks or bonds of companies at different phases of their corporate lifecycle can provide diversification. Newer, rapidly expanding businesses have distinct risk and return characteristics compared to older, more established businesses.


Asset Size

The past shows that market capitalization, which measures the size of a company, is a source of diversification. In general, small-cap stocks have higher risks and returns than those of larger, more stable companies.


Asset Location

The location of a business can also be a diversification factor. In general, locations have been divided into three categories: companies based in the United States, developed countries, and emerging markets.


Asset Sector

Diversification by industry is an additional essential method for mitigating investment risk. Investing in the stocks or bonds of companies in a variety of industries provides substantial diversification.


Asset Class

Lastly, one of the most important decisions made by investors is how much capital to allocate to stocks vs bonds. The decision to allocate a greater proportion of a portfolio to stocks as opposed to bonds increases growth, but at the expense of greater volatility.

What does the Data Show?

      Diversification may sound too good to be true in theory, but how does it hold up in practice? The following plots show various portfolio combinations to illustrate the multiple ways to diversify.

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      The plots compare returns for multiple equities (Walmart, Apple, Facebook, Carparts.Com, Verizon, Abbott, Google, and 20-Year Treasury) and various portfolios (Style, Size, Location, Sector, and Class) containing two of each equity. Let’s analyze what the five plots demonstrate. 

It is evident that diversification plays its role by reducing some of the volatility in the returns of the two equities while outperforming at least one equity at all times. This lines up perfectly with what was mentioned above stating “Diversification’s ultimate objective is to reduce portfolio volatility by offsetting losses in one asset class with gains in another asset class.”

This is precisely what occurs in the five plots and demonstrates why diversification is essential when making financial decisions. However, diversity is not only about selecting assets of various styles or sizes. It also boils down to correlation (click here to learn more!). Correlation helps analyze the relationship between the movements of two assets. In our case, each asset correlation is between -0.17 to 0.60. Negative to low correlations demonstrate the capabilities of diversification, by reducing the overall portfolio volatility. 

Diversification plays a critical part in investment decision-making, and understanding the many ways in which it affects how each asset differs can be crucial in uncertain times.

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All investors are unique.  The above characteristics are examples, but may not reflect your particular investor demographics or situation.  An advisor with Edgar Investment Management, LLC will assist you with finding the best type of account for you. 

Investment advisory services are offered through Edgar Investment Management, LLC, an investment advisor registered with the State of Texas. Edgar Investment Management, LLC only offers investment advisory services where it is appropriately registered or exempt from registration and only after clients have entered into an investment advisory agreement confirming the terms of engagement and have been provided a copy of the firm’s ADV Part 2A brochure document.

The content found on this website is developed from sources we believe provide accurate information and is for educational purposes only. The information on this website is not intended as tax or legal advice. Everyone’s tax and legal situation is different, so please consult trusted and knowledgeable legal or tax professionals for specific information regarding your individual situation. The opinions expressed and material provided on this website are for general information, and should not be considered a solicitation for the purchase or sale of any security.

Material and information found on this website is not intended as an offer or solicitation for the sale or purchase of any specific security, mutual fund, ETF, bond, or investment strategy.  

Investing is risky!  No guarantee as to performance of any investment is implied by this website.  Make sure you have evaluated your options and spoken with trained professionals before you implement any investment strategy.  Past performance is not indicative of future results.  

Please be advised that Edgar Investment Management, LLC is a financial advisory firm specializing in investment management and financial planning services. We do not offer or provide any CPA-related services, including tax preparation, tax planning, or other accounting services. If you require assistance with tax-related matters, we recommend consulting a qualified CPA or tax professional who can provide specialized advice tailored to your individual needs.

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