Reviewed by Jul 27, 2020| Updated on
Diversification is a strategy for risk management that mixes a wide range of portfolio investments. The rationale behind this technique is that an asset-built portfolio will, on average, yield higher long-term returns and reduces the risk of any holding or security.
Diversification aims to balance out unsystematic risk occurrences in a portfolio, so some assets' positive performance neutralizes others' negative performance. Diversification benefits holders only when portfolio securities are not perfectly correlated—that is, they react differently to market influences, often in opposing ways.
Diversification is a technique that incorporates a wide range of portfolio investments. Portfolios can be diversified across asset classes and sectors, as well as geographically, by investing in domestic and foreign markets. Diversification reduces portfolio risk, but can also reduce volatility, at least in the short term.
Like reduced risk and a buffer for volatility, there are many benefits of diversification. There are also drawbacks, though. The more holdings a portfolio has, the more time it can take to manage, and the more expensive it can be since the purchase and sale of many different holdings entails more transaction fees and commissions for brokerage. More fundamentally, the spread-out strategy of diversification works both ways.
Diversification brings down risk through investing across different industries, financial instruments, and other categories. Fund managers and investors often diversify their assets through asset classes and evaluate which portfolio percentages to assign to each.
Classes can contain:
Stocks— equity or shares in a publicly-traded company.
Real estate—buildings, land, natural resources, livestock, agriculture, water, and mineral deposits.
Bonds—government/corporate fixed-income debt instruments.
Exchange-Traded Funds (ETFs)—a marketable basket of securities that follow a commodity, index, or sector.
Cash and short-term cash-equivalents (CCE)—Treasury bills, money market vehicles, certificate of deposit (CD), and other low-risk, short-term investments.
Commodities—basic goods required for the production of other products/services.