Diversification Strategy

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk.

The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. The investing in more securities generates further diversification benefits, albeit at a drastically smaller rate.

Diversification strives to smooth out unsystematic risk events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others. The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated—that is, they respond differently, often in opposing ways, to market influences.

As investors consider ways to diversify their holdings, there are dozens of strategies to implement. Many of the strategies below can be combined to enhance the level of diversification within a single portfolio. Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Each asset class has a different, unique set of risks and opportunities.

The theory holds that what may negatively impact one asset class may be beneficial to another. For example, rising interest rates usually negatively impacts bond prices as yield must increase to make fixed income securities more attractive. On the other hand, rising interest rates may result in increases in rent for real estate or increases in prices for commodities.

There's tremendous differences in the way different industries or sectors operate. As investors diversify across different industries, they become less likely to be impacted by sector-specific risk.

For example, consider the CHIPS and Science Act of 2022. This piece of legislation impacts many different industries, though some companies are more impacted than others. Semiconductor manufacturers will be largely impacted, while the financial services sector might feel smaller, residual impacts.

Investors can diversify across industries by coupling investments that may counterbalance different businesses. For example, consider two major means of entertainment: travel and digital streaming. Investors hoping to hedge against the risk of future major pandemic impacts may invest in digital streaming platforms (i.e. positively impacted by shutdowns). At the same time, investors may consider simultaneously investing in airlines (positively impacted by less shutdowns). In theory, these two unrelated industries may minimize overall portfolio risk.

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