Diversification is the process of owning different investments that tend to perform well at different times in order to reduce the effects of volatility in a portfolio, and also increase the potential for increasing returns.
What is an Example of Diversification Strategy?
A simplified example of a diversification strategy is a street vendor who sells both umbrellas and sunglasses, with the addition of some tourist trinkets. Having a mix of products like this ensures that he or she can earn money on both sunny and rainy days and is also selling some products that can generate income regardless of the weather. By “diversifying” inventory, the vendor can mitigate some volatility in earnings because these items (assets) do not all perform best at the same times.
What Does Diversification Mean in Investing?
In the world of investing, a diversified portfolio is one that contains holdings across various asset classes – including equities, fixed income, and alternatives – because volatility can be better mitigated since the asset classes will not all fluctuate in the same direction when there are market movements.
Having a diversified portfolio can be a helpful tool for managing economic and psychological stress, but also means that you must continue to rebalance and adjust as the markets move. The most important thing to remember is to stick to your long-term financial plan and investing strategy, even (and especially) during market volatility.
What Are the Advantages of Diversification?
As alluded to above, there are several advantages to diversification, one being that you are better protected from excessive loss when markets are experiencing instability. For example, in March 2020 when the onset of Covid-19 resulted in huge drops in the markets and emotionally driven investment decisions, those who already had diversified portfolios were better positioned for stability and recovery, both materially and psychologically. Diversification helped alleviate the weight of a significant market drawdown and even benefited investors in other areas of their portfolios, like fixed income exposure.