Diversification means splitting your money among several investment options. When you diversify your portfolio, you try to ensure that at any given time, the value of some of your holdings might be down and some might be up, but overall you are doing fine. Diversification offers the investor a method to reduce risk.
Diversification of investments can be achieved in many different ways. Individuals can diversify across one type of asset class, such as stocks. To accomplish this, the investor purchases shares of leading companies across many different and unrelated industries. Many other diversification strategies are also possible. You can diversify your portfolio across different types of assets (stocks, bonds, cash), across industries or across regions such as states and countries.
Each of the traditional asset classes (stocks, bonds, cash) tends to produce the strongest terms under different market conditions than other asset classes. For example, stocks often shine when corporate earnings are strong and financial markets are expanding. Yet this same environment frequently has the opposite effect on bonds, so that they provide lower than average returns.
On the other hand, bond returns often rise in a period when stock values drop. That may happen when interest rates go up or when corporate earnings do not meet expectations. The smart investor has some money in both stocks and bonds to benefit from owning the one that is up while limiting their losses on the one that is down.
We’ve seen that when asset classes have a low correlation to each other, they can act together to enhance the value of your portfolio. Now, what is the optimal level of diversification, especially to those individuals investing strictly in stocks. According to many financial experts an appropriate diversified portfolio would contain about twenty to thirty securities. Unfortunately, these simple numbers do not serve as a good guide. Managing twenty to thirty securities can be confusing and difficult. This is a reason why mutual funds have become so popular. Everyone has their own personal level for managing and tracking individual securities. You should find yours.
Our analysis shows that for a portfolio to perform best and remain diversified a specific strategy should not comprise more than 5% of an entire portfolio.