Understanding How To Diversify Your Investment Portfolio

By Ronald Kimmons. May 7th 2016

One of the central aspects of investment success is risk management. Investors minimize their exposure to risk through diversification – the spreading of cash for investment into a collection of mediums. Investors may use a number of strategies to accomplish this goal. Each strategy has its own virtues and limitations, and they may often be used concurrently. Here is some helpful information on the different ways you can diversify your investment portfolio.

Vertical Diversification

Vertical diversification is characterized by the purchase of interests in various types of investment instruments. Investors who seek to meet aggressive goals and see their wealth expand exponentially must do so by taking risks. Those who do not want to take risks must be willing to accept lower levels of reward. While some investors pick one strategy or another, other investors practice strategic diversification by simultaneously making some investments that are relatively safe and other investments that are aggressive and risky. The classic example of such diversification can be seen in the choice of investment instruments – specifically, stocks versus bonds. Stocks are usually riskier, more aggressive investments, while bonds are safer, less lucrative investments. You can vertically diversify your portfolio by diversifying the types of instruments in which you invest – putting your money toward both stocks and bonds, for instance.

Horizontal Diversification

Horizontal diversification is characterized by one’s investment into different instances of the same class of investment instrument. For example, for the sake of vertical diversification, an investor may decide to invest 60 percent of her cash into stocks and 40 percent into bonds. To engage in horizontal diversification, she may opt to buy those stocks and bonds from a collection of different companies instead of just one or two.

Company Diversification

Company diversification is characterized by the spreading of assets across a spectrum of companies within the same industry. For example, someone who thinks that the video game industry is about to see dramatic growth may decide to buy stock in a dozen different competing corporations instead of just one. In this way, investors can take advantage of an industry’s growth while protecting themselves from the financial losses that could occur due to one particular company’s poor decisions. An example of such diversification can be seen in Microsoft’s massive purchase of Apple stock in the 1990s. By investing in a competitor in this way, Microsoft ensured that it could profit regardless of which company gained market share in the near future.

Industry Diversification

Industry diversification is characterized by the spreading of assets across a diverse set of industries. For instance, investors may purchase stocks or bonds for companies that work in agriculture, transportation, aerospace, manufacturing and computer software. By doing so, they can minimize their exposure to the shocks that affect entire industries, such as technological developments and changes in government regulation.

Market Diversification

A collapse in the housing market in Switzerland can adversely affect every industry in Europe. Similarly, a revolution in Guatemala can adversely affect every industry in Central America. For these reasons, it is important for investors to diversify their portfolios by investing not only in different companies or industries, but in different markets altogether. For instance, an American investor can invest not only in companies listed on the New York stock exchange, but also in companies listed on the stock exchanges in London, Shanghai, Moscow and Tokyo. In this way, investors can protect their wealth against the shocks that affect entire countries or regions.

Equity Vs. Debt

An equity investment represents a full or partial ownership of something, such as a company, a piece of real estate or a piece of intellectual property. A debt investment represents a commitment that a borrower makes to repay the lender the amount borrowed, plus interest, according to a set schedule. Purchasing stock gives an investor partial ownership of a company, while purchasing a bond gives an investor the right to collect a certain amount of cash from that company at a certain point in time. While individual investors have long been able to put their money toward equity investment in a number of ways, they have traditionally only been able to engage in debt investment through corporate and government bonds, leaving other debt investment options to the banks. However, a number of Internet-based services now empower peer-to-peer lending, which enables individual investors to lend money to other individuals and small companies. Making loans through such platforms is just another method of portfolio diversification. When investors make good loans, they deliver steady, predictable returns that often outperform investment options such as mutual funds. Diversification is important in these situations as well: investors should spread their cash over a collection of loans instead of just one.

Research

The primary hurdle of diversification for independent investors is the matter of research. Hedge funds have analysts and managers who make big bucks researching investments full-time, but the average independent investor often has to dedicate much of his or her time to a job or some other activity. This makes investment research difficult – especially since diversification requires investors to research a broad range of firms.

The bottom line is that diversification is crucial to any investment strategy. Therefore, you should keep these different kinds of diversification in mind when structuring your investment portfolio.

Sources

More in category

Related Content