It’s essential for investors to learn how to optimize their chances of successfully investing for retirement by minimizing their investment risks through diversification. Here are some of the reasons why it’s important to diversify when investing.
In this article:
- What Is Diversification?
- Why Portfolio Diversification Is Important
- Diversification and Market Risk
- Diversification and Credit Risk
- Diversification and Liquidity Risk
- Diversification Strategy: By Type of Investment
- Diversification Strategy: By Industry
- Diversification Strategy: By Issuing Entity
- Mutual Funds: An Excellent Investment Diversification Tool
Portfolio Diversification and Why Investors Should Learn How to Do It
What Is Diversification?
Many fund managers, individual investors, and financial planners consider diversification an important part of their investment strategy. Investment experts define diversification as spreading one’s investments across different types of financial assets.
In more metaphorical terms, it means putting one’s eggs in different baskets.
Why Portfolio Diversification Is Important
Diversification is important in investing because it can minimize potential complexities associated with investment portfolios. These financial complexities—more commonly known as risks—may include market, credit, and liquidity risks.
This refers to the possibility that the market value of assets in a portfolio will fall to the point that returns on investments become negative. An example of this is when the stock market crashed during the 2008 sub-prime mortgage crisis, which left many portfolios with negative returns on their investment.
Credit risk refers to the possibility that issuers of debt-related securities, like bonds and commercial papers, may not be able to pay interest or pay back the principal amounts owed when they fall due. Investors can easily assess the credit risk scores of debt-issuing companies via credit ratings issued by reputable agencies like Standard and Poor’s and Moody’s.
This refers to the possibility that investors may not be able to easily liquidate their investments or liquidate them at the price they want.
- Low Liquidity Risk — Financial securities with a high daily turnover or trading volume have a lower liquidity risk.
- High Liquidity Risk — In comparison, financial securities with a low daily turnover have a higher liquidity risk.
Liquidity Defined: The ability to convert non-cash assets into cash. The more liquid a non-cash asset is, the easier it is to convert it into cash.
Diversification and Market Risk
When it comes to market risk, diversification can minimize marked-to-market losses due to unfavorable movements in the prices of financial securities. An example is an investor who spreads investments equally among U.S. Treasuries (50%) and stocks (50%).
Marked-to-Market Losses Defined: Marked-to-Market (MTM) refers to a system of valuating assets based on their prevailing market prices. Marked-to-market losses refer to losses resulting from depressed market prices of investments while marked-to-market profits refer to profits resulting from higher market prices of investments.
The Relationship Between the Prices of Debt Instruments and Stock Prices
Prices of debt instruments, like U.S. Treasuries and Commercial Papers, have an inverse relationship with those of stocks. This means when the prices of stocks go up, the prices of debt instruments normally go down, and vice versa.
- When stock markets go down, like what happened during the 2008 sub-prime mortgage crisis, investors scramble to transfer their money to safer assets like debt instruments. As a result, the market prices of debt or fixed-income securities typically go up.
- In the case of this investor, diversification can offset or minimize marked-to-market losses resulting from plunging stock prices. A corresponding increase in the market prices of debt instruments like U.S. Treasuries, which account for 50% of this investor’s portfolio, may result in higher marked-to-market profits on this particular type of investment that can offset and minimize losses from stocks.
Diversification and Credit Risk
How does a diversified portfolio benefit an investor? Here’s an example.
- An investor’s fixed income or debt instruments portfolio is composed equally of the following:
- U.S. Treasury Bonds (33.33%)
- Apple, Inc. 10-year commercial papers (33.33%)
- A five-year commercial paper of a start-up company (33.33%).
- After two years, the start-up company closed shop and consequently defaulted on its payments.
- Because the investor diversified this portfolio across three different borrowers, the default of one didn’t result in a total loss. Only 33.33% of the fixed income portfolio was lost instead of 100%.
What if the investor invested solely in the commercial paper of the start-up company to get significantly higher yields? The closure of that start-up company would’ve wiped out the investor’s entire fixed income portfolio.
Diversification and Liquidity Risk
By diversifying investments, investors can minimize liquidity risk for times when they may urgently need money. Here’s how:
- High Liquidity Investments — Investors can liquidate different types of investments at different speeds. Investments that are very liquid, (i.e., with high trading volumes) are the easiest to sell and convert into much-needed cash.
- Low Liquidity Investments — On the other hand, investments with low liquidity (i.e. low trading volumes) are the most challenging to immediately convert into cash. Sometimes, such investments can present very promising long-term returns that can be very hard to pass on.
Putting all or most of investible funds in assets with low liquidity can make fast liquidation of investments very challenging. However, splitting investible funds between very liquid investments, with potentially modest returns, and low-liquidity investments, with potentially high long-term returns, allows investors to take advantage of higher returns without compromising liquidity.
Diversification Strategy: By Type of Investment
One way investors can diversify their investments is by distributing investible funds across different kinds of investments. For example, investors can distribute funds between:
- Fixed income instruments
As mentioned earlier, some types of investments behave in opposite ways compared to others. For example, stock prices generally move up when prices of fixed income investments go down, and vice-versa.
By splitting investment funds across different types of investments, investors can limit potential losses. It can also help generate superior returns because of higher returns on some of the diversified portfolio’s assets.
Diversification Strategy: By Industry
After diversifying total investible funds by type of investment, seasoned individual investors and fund managers diversify investments further. Within specific investment types, they also diversify across industries.
Take, for example, a portfolio of stock investments. Stock prices for stocks from different industries may react to specific economic developments in different ways.
- Stock prices of companies in export-dependent industries may react differently compared to companies that aren’t dependent on exports to substantial changes in the value of the U.S. dollar. Profits of export-oriented companies react more to substantial movements in the value of the U.S. dollar than those that aren’t.
- When the U.S. dollar’s value depreciates, it makes products of export-oriented companies cheaper and may increase sales abroad.
- When the U.S. dollar appreciates, sales of such companies abroad may go down because it makes their products more expensive.
Depreciation Definition: This occurs when a currency, like the U.S. dollar, depreciates in value against other currencies, making it “cheaper” compared to other currencies. This makes dollar-priced goods cheaper to buy using other currencies. When dollar-priced goods become cheaper, demand for such products may increase abroad.
Because sales is the single biggest determinant of a company’s profitability, changes in sales can affect the stock prices of companies. Higher sales equal higher income and higher stock prices, and vice-versa. However, sales of non-export oriented companies may not change much due to changes in the dollar’s value.
As a result, their stock prices may not change much even if the exchange rate does.
Diversification Strategy: By Issuing Entity
Even after diversifying by industry, seasoned individual investors and fund managers diversify their portfolios further across different issuing entities. This is because different management teams run companies in the same industries differently.
- Amazon and Target are both in the retail industry.
- Amazon is enjoying solid profits while Target plans to close six outlets in 2019.
Despite being in the same industry, these two companies are moving in different directions revenue-wise. It’s because, while in the same industry, they belong to different sub-industries in the retail sector.
Amazon is the undisputed leader in online retail, which is becoming more and more popular as the years go by. And, because more items in physical stores like Target are now selling on Amazon, many of Target’s outlets continue to lose sales and income.
Through diversification, investors can minimize their risk of losing their investments in a specific industry when an issuing entity experiences financial troubles. Diversification can also greatly reduce potential marked-to-market losses due to one or two issuing entities’ poor financial performance.
Mutual Funds: An Excellent Investment Diversification Tool
Many newbie or first-time investors may feel overwhelmed with diversification. It’s probably because they still lack the investment knowledge and experience necessary for diversification.
New investors do have an option for easy and effective diversification—mutual funds.
A mutual fund is a type of investment that contains different financial assets. By investing in a mutual fund, an investor can invest in different assets within the mutual fund.
Investing in mutual funds helps investors in one big way—it provides immediate portfolio diversification.
- A balanced mutual fund may contain high-yielding fixed income securities as well as blue-chip stocks.
- Within each diversified investment type comes different issuers from different industries, and within those industries also come varied issuing entities to ensure even greater diversification.
The best part of it is that investors don’t have to bother with choosing which securities, industries, and companies to invest in. The mutual fund’s investment managers do all the work researching, monitoring, and managing the funds invested.
Investing for one’s retirement isn’t just about choosing financial assets with the highest potential yields—it’s also about minimizing potential losses. Through portfolio diversification, investors can get good returns on investments while minimizing the complexities associated with investing.
When you look at your IRA portfolio, do you think it’s well-diversified or is it concentrated on a couple of securities only? Tell us what you think about diversification and how it relates to your own IRA portfolio in the comments section below.
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