A change is much needed in all aspects of finance. Sticking to a traditional portfolio for a very long time may attract losses and at some point in time, the growth of that particular sector might die. Usually, in the course of business, the owners diversify their product line to different paths so that they can mitigate the risk of one line with another. Likewise in investment, the investors invest in different portfolios with different risk and return to mitigate loss. This strategy of diversifying the investment into different areas or portfolios is known as the diversification strategy.
Meaning of Diversification Strategy
A diversification strategy is a practice where investors invest in different portfolios of different natures. All the investments vary in risk to return. A diversified portfolio investment includes different assets and investment vehicles. As we can see this will help you to eliminate the risk of incurring a single loss and difficulty in recovery. Diversification helps to eliminate unsystematic risk in investment. Unsystematic risk is also known as a specific risk that deals with the risk related to a specific investment option or company. By diversifying the portfolio, you can bridge between the different investments and thus in return reduce the risk arising from a specific investment option.
A diversification strategy not just allows the investor to invest in different assets or investment vehicles, but also helps the investors to invest beyond geographical borders. Diversification also promotes international investment and enhances the portfolio of the investors.
Why is Diversification a Recommended Investment Strategy?
Diversification is a recommended investment strategy because it helps to spread risk across a variety of investments. By investing in a mix of asset classes, sectors, and geographies, an investor can potentially reduce the impact of any one investment performing poorly. Additionally, diversification can also help to increase overall returns by allocating assets to areas that may have higher growth potential. This strategy also help to minimize the overall risk in the portfolio by balancing the investments. This way the investor has a better chance of achieving his investment goals.
Strategies of Diversification Strategy
Diversification is usually done in a systematic and well-planned way. Strategies are adopted according to the preference of the investor and the purpose why he is diversifying his portfolio. Also, certain factors are to be considered while adopting a diversification strategy for investors. There are different strategies adopted by investors to diversify their portfolios:
- Industry expansion:
Usually, investors look into investing in stocks and bonds. They change their investments in these two instruments. but the actual diversification is made to the best use when they spread their investments across the industries. They invest in stocks and bonds as well as real estate. There should be a mixture of industries to optimize investments.
- Periodic checking of diversified funds:
The investor needs to keep an eye on the diversified funds. He should make sure that funds are equally balanced. The more the balance is maintained the more there is a surety of success.
- Exploring the alternatives:
Investors should make sure that they invest in the assets and also investment vehicle funds. They need to diversify and explore all the alternatives available to them and minimize the opportunity cost.
- Go beyond boundaries:
The investor should not be stopped by geographical boundaries. He should explore the opportunities available and go all way to stabilize the portfolio and bridge the gap of risk.
- Diversify within the available alternatives:
In case the investors are not provided with many options it is they diversify among the given asset classes. They invest in both fixed and regular income-giving asset classes.
- Correlated funds:
Diversification happens best when the investor is best aware of the correlation between the funds and risk. The diversified fund should be of both high-end yield and low-end yield. If one goes down, we can mitigate the risk with the other option available.
- Risk and yield strategy:
The investor should make sure that he is risk tolerant and can get income on regular basis. To ensure this the investor takes into consideration the different options available and invests in the different plans according to the risk tolerance, whether moderate or high, and makes sure these investments are a combination of both long-term and short-term.
Advantages of Diversification Strategy
As most investors prefer diversification, they should possess certain advantages over normal portfolio planning. They are mainly:
- Reduction of risk: The risk is reduced to the minimum as there is a bridge between all the investments. The loss from one investment is mitigated by another investment. There is a shockproof cover over the investments made.
- Enhanced returns: The investor deposits in both long-term and short-term investments. There is a return periodically as well as a long-term return on a future date to meet the upcoming requirement of the investors.
- Exploring opportunities: Investors are exposed to more investment options available to them and they are given a chance to choose among the different alternatives available to them. they now dare to take risks and invest in more and more investment avenues.
- Stability and high return in related sectors: The investment return will be always there for a person with a diversified portfolio as people invest in differently correlated investments. In case of a high return from a company in a particular sector, all companies in that sector will experience a high return and thus increase the pay-out profile of the sector as a whole.
- Adjust with the business cycle: In case of depression in one sector, they can mitigate that loss from the sectors which experience a boom in the cycle.
Limitations of Diversification Strategy
Even though there are numerous advantages to the diversification strategy but there are certain reasons why people do not prefer a diversified portfolio. The main reasons are:
- Time-consuming and expensive: The investor has to keep aside more time to manage all the funds invested in different funds. Management is a lengthy process. As the funds are invested in different avenues the investor is entitled to pay fees and commissions in each avenue which is a burden to the investors.
- Difficulty in computing tax: As the tax provisions are different for different investment options the investors find it difficult to calculate the tax payable by them regarding their investment.
- Over diversification: New investors may be keen to explore more options available which may result in buying risky and fewer-return investments. This might lead to over-diversification and the investor is exposed to more loss than before.
Everything in the investment area is safer when it is spread across different areas. Just like that diversification strategy is a shockproof cover offered to investors so that the investors are not exposed to the risk of high loss in investments. The investors spread their investments in different avenues and the investors mitigate the loss. Diversification is used by investors to expand their business to the international level as well as explore the alternatives available to them. Diversification strategies are the best strategy adopted by investors to build a stable portfolio and enhance their return on investment for a long period.