Last Updated on March 12, 2024 by ethinos
Investors and traders do several things to secure their financial portfolios against risk. One of the key ways to protect your portfolio is by balancing the assets in it and spreading them out in a financial way. This method, popularly known as “portfolio diversification” can give your trading account the edge when it comes to risk management. In simple terms, portfolio diversification, or just diversification, means that an investor includes a variety of investment instruments or securities from different channels, sectors, and industries in their financial portfolio.
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Balance Your Trading Account Portfolio
The idea behind portfolio diversification mirrors the old saying of “not putting your eggs in just one basket”. If you spread your wealth across several investments, in the event one investment fails, you still have the rest to make up for any shortfall. In this way, your capital remains secure and you may ensure profits as well. The extra degree of security you get can be measured in the profits made up by other investments in the portfolio relative to any individual investment of the same type or size.
How do You Diversify?
Which trader or investor is not looking to minimise the risk in any portfolio? You may say that every investor seeks the reduction of risk to maximise profits. This is especially so for the long run. When you follow the method of diversifying your portfolio, you effectively open a trading account and make your investment in more than a single asset. So, you may not just invest in company shares, but also in commodities, bonds, hybrid assets, REITs, and more in your financial portfolio. Furthermore, within each class of assets, you may further diversify your portfolio according to sectors and industries. So, if you have stocks in your portfolio, you may have a combination of technology, finance, and pharma shares instead of shares belonging to just one of these sectors. Consequently, what a well-diversified portfolio does is spread your investments in a range of securities.
Diversification and Correlation
In any financial portfolio, whether a stock market portfolio or any other, you can gauge a correlation between your investments. For example, you may see that some of your assets are making profits, and others are making losses. This tends to be a negative correlation. The degree of the movement could be different but the correlation ensures that when some assets lose their value in a single portfolio, other assets in the same portfolio possibly compensate for the loss. If you select different asset classes as well as different securities that react differently to any systematic market risk, you can hedge against the effect that negative circumstances have on your financial portfolio.
Additional Read: Types of Trading Accounts in India
The point to make here is that different investments should not be correlated to each other, otherwise, they will be vulnerable to the same risk in the same degree. Therefore, for optimal diversification (or for diversification to have a positive effect on your portfolio) your assets and investments should not be correlated. This brings us to different kinds of diversification methods.
Kinds of Diversification
Why is diversification typically successful and advised for investors? The reason why portfolio diversification works is that different assets’ prices do not move in the same direction or move together. Therefore, in any trading account financial portfolio, an investor may randomly select different securities in the hope this lowers the risk in the financial portfolio just because of the varied nature of the chosen securities. This is known as “naive diversification”, where methods of selecting assets are not sophisticated and calculative.
In another kind of method of diversification, optimal diversification, the concentration is on locating assets that have correlations that are not positive to one another. In this method, a few securities are determined with a negative correlation. In this approach, more sophisticated than naive diversification, computers run algorithms to find the “perfect” correlation to lessen risk and give optimal profits.
Diversification in Your Trading Account
Whatever method of diversification you use can be an effective strategy to mitigate your risk in a financial portfolio. After all, some diversification is better than none, simply because of the fact that diversification results in the spreading of your investable capital over a variety of assets. Under typical market conditions, a portfolio that is well-diversified will lead to minimising your risk in investment with some assets making up for the losses of others. In extreme conditions, portfolio diversification may not be very effective, but some diversification does help you preserve your capital and maintain your finances as optimally as you can.
How you can go a step further than just randomly selecting different assets and asset classes is by carefully choosing for investments with negative correlations rather than those that may tend to move in the same way with the same market impact. In this way, you make the variety of assets in your portfolio work in the best way that diversification affords.
Disclaimer: Investments in the securities market are subject to market risk, read all related documents carefully before investing. This content is for educational purposes only.
