What Is Diversification?
Don’t put all your eggs in one basket! That’s just another way of saying diversification. Fund managers and investors try to find the right balance for their portfolios constantly. Meanwhile, others go all-in on a single stock or industry. Which strategy is the best? There are winners in both categories, but in the long run, diversifying works best. Once again, the investment strategy and goals are important factors. Let’s take a look at both sides of the coin.
What Is Diversification?
Diversification is an investment strategy with the ultimate goal of spreading risk in a portfolio.
Investors hope that the portfolio will have higher returns over a long period of time.
Diversification works best when the various components of a portfolio act differently to the same economic event.
Some will gain in value while others will lose value. In other words, they are negatively correlated. Meanwhile, positively correlated investments will rise and fall simultaneously. Volatility is spread across all assets to prevent large single-day or period drops.
The following section will dissect the what is diversification strategy more in detail.
How Do diversify Efficiently
There exist many ways to diversify efficiently. Investors have access to more than stocks for their portfolios. What is diversification? The options below have different timeframes, liquidity, availability, and risk level.
- Stocks – Large/Mid/Small Cap
- Emerging Markets – Developing Nations
- Fixed-Income – Bonds
- Real Estate and REITs – Personal and Institutional
- ETFs and Mutual Funds
- Cash and Short-Term equivalents
- Alternatives – Hedge Funds, Gold, Oil, Crypto, Derivatives, etc.
- Foreign Investments
Different investors will choose a different strategy. Wealthier individuals will choose to hire someone to invest on their behalf. Those with more time and expertise will do everything themselves. Banks will offer their own diversified products (mutual funds) with higher fees. It is up to the investor to sit down and evaluate their options based on their experience and the funds available.
What Is Diversification With a Financial Institution
Individuals who invest with a financial advisor will generally see their returns grow over time. They offer funds that range from very conservative to very aggressive. The main difference is the allocation in stocks and foreign funds. Generally, returns will hover around 6-10%. Below, I will give an example of an allocation for various investor types.
60-65% Fixed Income
5-15% Cash and Equivalents
55-60% Fixed Income
5-10% Cash and Equivalents
35-40% Fixed Income
5-10% Cash and Equivalents
25-30% Fixed Income
5-10% Cash and Equivalents
0-10% Fixed Income
0-10% Cash and Equivalents
Financial institutions will only offer more diverse investment options to wealthy individuals ($500k +). I worked for a bank for almost 5 years. In my experience, banks and financial institutions will often push their own products over their competition. Their commission is much higher.
Before investing with them, make sure to read the fund facts and to look at what the competition offers. Some mutual funds charge over 2% fees. Returns can also be better elsewhere in the same industry.
What Is Diversification With Algorithms
Some institutions offer computer-based software for investing.
An algorithm takes care of the buying and selling. It also comes with lower fees since the computer doesn’t need a wage or a bonus.
The algo will find optimal buying and selling opportunities. However, it may not be that simple to trust an AI.
Many opt to build their own trading bot. Many companies offer this product. Below are two examples.
Investors who wish to invest by themselves have many different options in their arsenal. Most alternative investments aren’t directly available to everyday investors. Therefore, a mix of stocks and ETFs is an excellent start. It is important to pick between different categories.
- Industry and sector
- Market capitalization
- Growth vs Value
- Active or Passive Management – Rebalancing the fund
Most financial institutions offer self-directed investment accounts. Investors can buy a wide range of products from different institutions.
What Is Diversification With Averaging
Whether you are investing with a financial institution, it is wise to add funds on a bi-weekly basis, or whenever your paycheck comes. This strategy allows investors to take advantage of highs and lows. Beware of fees for every purchase if there are any.
This example can apply to another real-life activity. How often do we refill our gas tanks? When it’s almost empty, halfway through, once a day? It’s best to buy gas regularly to avoid paying more on a day when gas is more expensive. We might also get lucky and refill on a good day. Over the long-term, refilling on a regular basis works best.
Pros and Cons of Diversifications
Here is a resume of what we have seen so far.
- Reduces portfolio risk
- Higher long-term returns
- Less volatility
- Use of new investment resources
We haven’t seen any negative aspects of diversifying.
- Short-term gains are limited
- Gains are not guaranteed
- Managing different assets requires a lot of knowledge and time unless it is done by a professional
- Fees for transactions and commissions
At the end of the day, it is very difficult to obtain a perfectly diversified portfolio. The easiest option is to invest in an existing ETF or index fund. In the next section, we will take a look at various existing portfolios and YOLOs that happened in the last quarter.
Diversifying VS YOLOing
Do you know the difference? You might think there doesn’t need to be a distinction made between the two because they’re so different. But when it comes to trading or investing, people get a little crazy.
First, let’s look at ETFs that cover popular sectors.
S&P 500 (NYSEARCA: SPY or IVV)
Any index that follows the 500 biggest companies on the US stock market is worth a look. Furthermore, fees are often below 0.1% yearly. It is naturally diversified, although heavy on tech.
1-year return: 12.20%
5-year return: 83%
NASDAQ 100 (NASDAQ: QQQ or TQQQ)
ProShares and Invesco offer two very good ETFs following the top 100 non-financial companies on the NASDAQ. Their stock allocations are different and fees are below 0.2%. The index is very tech-heavy which can be a good or a bad thing. FAANG+ stocks are beginning to trade in different directions which can allow for more diversification in the next years.
1-year return: 4-6%
5-year return: 160-620%
Russell 2000 (NASDAQ: VTWO or NYSEARCA: IWM)
If we take the top 3000 US companies and remove the top 1000, we obtain the Russell 2000 index. Vanguard and iShares offer two good ETFs tracking this index. It is obviously following smaller-cap companies at different growth stages. These stocks are less predictable in the long term.
1-year return: -10.97%
5-year return: 43-44%
Dividend ETFs (NYSEARCA: VIG or SCHD)
Vanguard and Schwab offer two very good options for a dividend ETF. Both their expense ratio is 0.06%. Their top 10 holdings are very recognizable. On top of solid growth, they both offer quarterly dividends of 1.67% and 2.91% respectively.
1-year return: 11-14%
5-year return: 71-74%
Environment, Social and Governance ESG (MUTF: VFTAX or NASDAQ: ESGU)
What is an ESG fund? It is a fund that invests in socially responsible and sustainable companies. Once again Vanguard and iShares both offer good options. Ironically, the term ESG can fit any company. Microsoft, Tesla, Amazon, and Meta can be found in the Top 10 holdings. Oil and arms companies won’t be included.
1-year return: 9%
5-year return: 65-88%
There is a variety of other ETFs that are more industry-specific. Once again, it is important to consider numerous factors before choosing one for a long-term investment.
In my opinion, this is the most important section of this article. It can be a life-changing decision that can affect your life forever.
If you choose this strategy, you have to be ready to lose your entire investment.
If the decision keeps you up from 9:30 until 15:30 and your index finger keeps hitting that refresh button, it is not a wise strategy.
The best way to YOLO is to buy options (on margin for bonus thrill).
One of the most famous is u/DeepF*ckingValue with his overly successful GME calls.
The number of successful options is way outnumbered by unsuccessful ones. However, once you find yourself on the winning end, it becomes an ecstatic feeling. Returns and losses can be far greater than from simple funds trading.
Now that we all know how to attempt portfolio diversification, it’s time to put it into practice. Or not…just YOLO into Tesla or Bitcoin calls. A balanced portfolio is always a better long-term choice. You can either go to a financial institution and let them pick one for you, or choose between the many existing ones. Make sure to do your own due diligence ahead of time.
If you want to learn more about how you can profit from the stock market, head on over to our free library of educational courses. We have something for everyone, including trading options for those with small accounts.