The Benefits of Diversification

When an investor is thinking of becoming a client, the first thing we do is conduct a free portfolio review. Often the portfolio contains either not enough stocks, or too many. This means that the first tip I can give someone is to ensure you have some proper diversification. The stock market can be rather volatile, so one way to protect you from adverse movements to your share portfolio is to diversify. Diversification is a strategy which involves acquiring shares from different sectors to reduce the volatility of the portfolio. The term gets thrown around a lot so what does it really mean?

Diversification reduces risk

Portfolio diversification reduces long term risk.

For example, if you have two stocks and one stock has dropped significantly in price and the other stock has risen in price, your losses will be reduced by the gains from the second stock.

You can diversify by selecting stocks from different industries. Sometimes there is no way to anticipate a negative downturn for a particular industry so if you diversify, then you can offset your losses from a declining industry to a growth industry. Sectors with low correlations to each other will further minimize your risk.

You can also diversify by selecting stocks from different sized companies. Smaller companies tend to be more risky than larger companies

Increased returns – Diversification can also enhance your returns over long periods of time. If the outlook for one industry is negative, there may be another industry which may be growing. If you had all your money in one stock or in one sector of the stock market and that sector performs badly, you do not have any other investments to offset that loss. A diversified portfolio also allows for the capacity for riskier trades as the overall risk of the portfolio would be balanced so the risk is lower. Hence this can generate higher returns.

Achieving more than one financial goal – Diversification allows you achieve multiple financial goals. You may have stocks which are high yielding, that is, generating good dividend income and you can also have stocks with great capital growth so you can achieve the benefits of both strategies.

Allows for Rebalancing – Diversification also allows for rebalancing. Rebalancing forces the stock selection in the portfolio to be broad so they are not just concentrated in stocks which have performed well.  This would be a risky strategy as there would be no gains to offset the losses if these stocks fall in value. This allows you to mitigate your risk.

Although diversification has vast benefits, you can also over diversify if you have too many stocks.  Once you have acquired the 20th stock in your portfolio, then you are close to the most ideal level of portfolio diversity. Your risk is reduced to about 29.2% with a portfolio of 20 stocks. Any additional stocks over 20 only reduces your portfolio risk by 0.8%, and this small benefit can be offset by the effort in trying to manage a high number of stocks.


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Disclaimer: The information in this article is general advice only. Read our full disclaimer HERE.