What is Diversification?

What is Diversification?

What is Diversification?

At The Money Pouch, we understand that diversification is the key to protecting investment portfolios from stock market drops, but what is diversification and how does it help? 

Diversification is a risk management technique that mixes a wide variety of investments within a portfolio. The rationale behind this technique contends that a portfolio constructed of different kinds of investments will, on average, yield higher returns over a long time period and thus, pose a lower risk than any individual investment found within the portfolio.

Here is the basic concept. Let's say you invest in a company that has one factory that produces soft drinks. You have all your assets invested and then the factory burns down and you lose all your money. This is how the insurance industry flourishes and is also why it is important to diversify your assets by buying 20 or 30 stocks rather than holding just one. It is your insurance for the future. 

The Money Pouch takes diversification a few steps further. It holds not just an index of companies, but also holds US treasuries for safety. When stock markets panic and they think stocks fall, they often move to the safety of treasuries. So, we always keep a hedge in treasuries or cash.

The Money Pouch also buys and sells ETF shares on your behalf regularly to lock in profits and cut losses. By buying low and sellingh high, we can optimise your returns. 

Understanding Diversification

Diversification strives to smooth out unsystematic risk events in an investment portfolio, so the positive performance of some of the investments neutralizes the negative performance of others. As you can see, the benefits of diversification will hold only if the securities in the portfolio are not perfectly correlated. That is why at The Money Pouch, we hold both Treasuries and equity ETFs as they tend to be negatively correlated or at least not perfectly correlated. Often treasuries rise, whilst stocks fall, but this isn't always the case, they may both rise or both fall. The idea though is to reduce the risk.

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks is the most cost-effective way of reducing risk. Investing in more securities yields further diversification benefits, but at a lesser rate.

Further diversification benefits may be gained by investing in foreign securities because they tend to be less closely correlated with domestic investments. For example, an economic downturn in the U.S. economy may not affect Japan's economy in the same way; therefore, having Japanese investments gives an investor a small cushion of protection against losses due to an American economic downturn. 

Most non-institutional investors have a limited investment budget and may find it difficult to create an adequately diversified portfolio.

This fact alone can explain why ETFs have been increasing in popularity. Buying shares in an ETF can provide investors with a low-cost source of diversification.

Diversification and ETFs

While mutual funds provide diversification across various asset classes, Exchange Traded Funds (ETF) allow investor access to narrow markets such as commodities and international equities that would ordinarily be difficult to gain access to.

An individual with a $100,000 portfolio can spread the investment among ETFs with no overlap. If an aggressive investor wishes to construct a portfolio composed of Emerging Market equities, US Treasuries and uranium mining companies, for example, he can purchase stakes in the iShares MSCI Emerging Markets ETF | EEM, the iShares 20+ Year Treasury Bond ETF | TLT and the Uranium ETF - Global X Funds The specificity of the targeted asset classes and the transparency of the holdings ensure true diversification, with divergent correlations among securities, can be achieved.

At The Money Pouch, we recommend tried and tested investment portfolios which will maximise your returns, whilst reducing risk. 

Click here to see the annual returns for our investment strategies .

By using this website, you accept our Terms of Use and Privacy Policy. As with all investments your capital is at risk and the value of your investments as well as the income derived from them can rise as well as fall. Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections may not reflect actual future performance. Historical results do not include the transaction and management fees. All securities involve risk and may result in loss. This site is provided for information purposes only and is not intended as a recommendation or an offer or solicitation for the purchase or sale of any financial instruments. We do not provide financial advice to investors. Prospective investors should confer with their personal tax advisors regarding the tax consequences based on their particular circumstances. The Money Pouch assumes no responsibility for the tax consequences or returns for any investor of any transaction.