Portfolio diversification: What are the pros and cons?
Portfolio diversification strikes a balance between low-risk and high-risk holdings
Portfolio diversification involves ensuring that your cash is spread out across a multitude of investments. It gives you the chance to mix things up and explore opportunities with an array of assets, and strike a balance between low-risk and high-risk holdings.
Let’s begin by looking at some diversification examples. Some traders may choose to focus on stocks, and reduce risk by investing in several companies instead of one. They may opt for a mix of established, profitable corporations and fledgling start-ups.
If a young company thrives, the potential returns can be considerably higher than what’s on offer from a market-leading blue-chip stock. That said, a firm with a steady stock price and consistent dividends can mitigate the financial impact if the bet doesn’t pay off.
Asset diversification involves spreading capital across a range of financial instruments. Here, an investor may own stocks, fixed-income debt instruments such as bonds, commodities such as gold, and cash. One of the main advantages of diversification can be the knowledge that a portion of the funds can be easily accessed if they are needed all of a sudden.
A blend of short-term and long-term investments, plus cash savings, prevents capital from being tied up and out of reach on a rainy day.
Why diversification is important
Portfolio diversification helps investors weather the storm of turbulence in the markets. Someone who only owned shares in airlines, for instance, would suffer if oil prices soared. Savvy traders can also distribute risk by investing in foreign markets. Although a prolonged economic downturn in the US can mean misery on American exchanges, markets in developing economies and on other continents may not suffer the same declines.
In recent years, there has been an explosion in funds – services that handle the diversification on an investor’s behalf. These funds can deliver exposure to dozens of different companies across several sectors and countries, and eliminate the need to buy shares individually.
Diversification pros and cons
Some of the benefits associated with this investment strategy include:
· Reducing losses: Putting all of your eggs in one basket can have disastrous results – especially if a recession hits;
· New adventures: If a trader is interested by an investment opportunity, but is reluctant to commit all of their capital, portfolio diversification gives them the chance to limit their exposure;
· Long-term growth: Asset diversification means investors have less chance of missing explosive growth in one particular asset class. While equities may offer the greatest returns one year, fixed-income instruments may dominate the next. A well-diversified portfolio can help cover all the bases.
Bear in mind, however, that there are also some disadvantages of diversification, such as:
· It can limit gains: In the short-term, it is possible that investors will miss out on high returns because their money is tied up in low-risk assets;
· It’s complicated: Finding a perfectly balanced portfolio isn’t easy, and it can be incredibly time-consuming. Ending up with investments that are too low-risk or too high-risk can have equally disappointing consequences;
· Greater expense: Buying into an array of assets usually means higher fees, eating into the bottom line.