Diversification aims at reducing portfolio risk by spreading capital over different investments. Here’s what you need to know about this risk management strategy, its advantages and disadvantages.

What is diversification?

Diversification is a core concept in risk management for investors. It is a common practice of spreading investments across different securities, asset classes, and geographies. The primary objective of this strategy is to reduce exposure to any single asset and consequently limit the downside of a portfolio’s volatility.

Diversification strategies

“Do not put all your eggs in a single basket” is the perfect idiom for not risking all your capital in a single investment. Market participants should consider investing in areas of the market that would react differently to adverse events. The portfolio’s securities should not be perfectly correlated to attain diversification. Theoretically, this can generate gains in one portion of the portfolio to offset losses in another.

Investors, whether institutional or individual, can employ any of the following diversification strategies, or ideally, altogether.

Diversification across asset classes

As the name suggests, this strategy is all about investors spreading investments across asset classes. They then determine what percentages of the portfolio to allocate to each in a process known as asset allocation. In the context of publicly traded securities, typical asset classes include stocks, bonds, real estate, commodities, cryptocurrencies, cash and cash equivalents.

Diversification within asset classes

Another layer of diversification is required after spreading investments across asset classes. This strategy is about investing in an array of securities within an asset class. It means picking securities that provide exposure to several industries. This protects the portfolio from being hammered down when a single industry takes a hit.

Diversification across international markets

This strategy encourages investors to look abroad for diversification. Foreign securities tend to be less correlated with domestic ones. If the domestic country’s markets were to perform poorly, it would be useful to have some investments in foreign markets to mitigate risk and balance the portfolio.

Advantages of diversification

One of the diversification perks is reduced risk, unsystematic risk to be specific. It is also known as asset-specific risk (aka idiosyncratic risk) since it affects a company. This risk includes the company’s product success, management performance, and stock price. Business and financial risks are typical causes of asset-specific risk. Investors can reduce their exposure through diversification.

On the other hand, a systematic risk, also known as market risk, affects the market in its entirety. Common causes include pandemics, wars, instability to name a few. No level of diversification can mitigate systematic risk.

The second benefit of diversification is a smoothed portfolio volatility. Diversification can offset the high volatility of riskier assets with the introduction of uncorrelated securities. In the long run, a well-diversified asset portfolio will end up with a lower overall volatility and could potentially generate higher returns on a risk-adjusted basis.

Disadvantages of diversification

Diversification doesn't exist without any drawbacks. While it can limit the downside by averaging out volatility in a portfolio, it can have adverse effects as well. As the level of diversification increases, returns will be more likely to mimic the market performance — a situation investors may want to avoid if they hope to become the next "Oracle of Omaha" (aka Warren Buffett).

Over-diversification can also be time-consuming since great stock picking doesn't happen overnight. If investors want to stuff more securities in their portfolios, they need to rack up hours of screen-gazing research — which can, in some instances, end up as loss-making bets.

Another drawback is that diversification can be expensive. The more holdings a portfolio has, the more expensive it gets due to transaction fees and brokerage commissions.

ETFs and diversification

Exchange-traded funds (ETFs) are known for providing instant diversification. They are designed to track a diversified basket of securities. When investors buy an ETF share, the capital is automatically spread across different investments.

ETFs come in all shapes and sizes. There are ETFs that belong to a specific asset class, e.g., equity ETFs or commodity ETFs. Similarly, there are those that track a certain sector or a theme like Cannabis ETFs. These funds can be either passively or actively managed. As a result, investors can build an all-ETFs portfolio that is well diversified. The portfolio will be made up of different funds reacting differently to adverse market events.