Diversified Investments Definition
A diversified portfolio of investments refers to a low risk investment plan that works as a best defense mechanism against financial crisis as it allows an investor to earn highest possible returns by making investments in a combination of a mixture of assets like stocks, commodities, fixed income, etc.
Types of Diversified Investments
There are different ways through which investments can be diversified, some of which are as follows:
#1 – Different Asset Classes
Different types of classes of assets have a different performance during the same economic event. So, different classes of assets such as stocks, fixed-income investments, commodities, real estate, cash, etc. can be included in a portfolio for diversified investment resulting in lowering the overall risk.
#2 – Different Individual Companies
Different individual companies perform differently in the market according to the different factors. So there should be a mix of such companies to reduce the overall risk of the portfolio.
#3 – Different Industry
The portfolio should have balance across multiple industries in the economy as there are some events that are industry-specific, and if that event occurs, the only value of investments in those industry instruments will only decrease. So, one should have investments in different industries so that the overall risk is low in a portfolio.
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#4 – Different Geographical Dimensions
Most of the investors have biases towards instruments issued in their home country. But there is always beneficial to diversify the portfolio internationally because an event that is negative for one country might have no effect on other countries or might have a positive effect on the other countries. So if the investment is diversified geographically, then a loss in investment in one country can be offset by international investments.
Example of the Diversified Investments
All of a sudden, the volatility in the share market increases, and then, in that case, there are chances that the people who have invested in stocks incur a huge amount of loss. In such cases, if a person is holding investments in some other class of assets as well like fixed interest investments or direct property which do not have an impact of the same event during the same period, then the return generated out of these investments will help in reducing the overall risk of the portfolio and smoothing the overall returns.
Advantages of the Diversified Investments
Below are some advantages of Diversified Investments.
- The diversified investments help in minimizing the risk of loss because if one investment doesn’t perform well over a particular period, then other investments in the portfolio may perform better in that same period helping in reducing potential losses associated with the investment portfolio if all the capital is invested under a similar type of investment.
- Sometimes the investments might not generate the returns as expected, so in that case, the diversified investment helps because through diversification, one is not merely relying on one source for generating the income, and he is investing in diversified investments.
- When the investments are well diversified, then lower maintenance will be required because care and attention are required to keep the investments performing well, and if there is a risky venture than a huge amount of time will be required in watching the markets. A well-diversified portfolio is generally more stable and less exciting, so once they are settled into a variety of class, then they can be there for extended periods and does not require a lot of maintenance.
Disadvantages of the Diversified Investments
The following are the disadvantages of Diversified Investments.
- If the investments are diversified, then the same could generate average returns only. Whereas in case one holds one security which suddenly spikes, then he can earn a good amount of profits which cannot be there in case of diversified investments. This waters down the profits and makes the portfolio look less than great.
- Additional transaction costs are also associated with diversified portfolios because one has to pay more in order to balance out the portfolio for maintaining the diversification.
- When there are various different assets in the portfolio, it is generally more difficult for a person to manage it as there would be too many investments in a portfolio. Whereas in case if there is only one security in which investment is made, then it would be easier to manage the same.
- Sometimes because the overall diversification risk of the portfolio increases because for making the diversified investment person might invest in the security of which he has little knowledge, or he doesn’t have any knowledge at all. One should always perform due diligence before investing.
Important points of the Diversified Investments
- The diversification strategy for investing in diversified assets mixes a different variety of investments for constructing a portfolio.
- Holdings in a portfolio can be diversified in several ways like it can be diversified on the basis of asset classes, industry-wise, company wise and also geographically.
- Diversification limits the overall risk of the portfolio risk but, at the same time, also mitigates the performance of the portfolio, at least if invested in the short term.
Conclusion
A diversified investment is a mixture of different assets like stocks, fixed income securities, commodities with the objective to achieve the highest return for the minimum level of risk. The diversification concept works because all the different types of assets have a different reaction with respect to the same event happening in the economy. All the assets in the diversified investments do not have a correlation with each other, and generally, when the value of some type of investment falls, then at the same the value of another type of assets may rise.
Due to this, the overall risk of total investments becomes low as in case of any event; there are some classes of assets which will give benefits and offsets the loss incurred in other assets because it is rare that all the classes of assets would have a negative effect by any one event.
Diversified investments help investors in achieving a smoother and more consistent return on the investments over the long and medium-term period. When the holdings of the person are diversified widely in divergent types of assets such as stocks, bonds, commodities, real estate, and cash, then it helps in reducing the overall risk of the portfolio as each asset class exhibits the different types of strengths and weaknesses with respect to risk and profitability.
So, maintaining holdings by a person in the majority of these assets class helps him in creating a stable portfolio, which then helps in increasing value over the period.
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