“Diversity is the one true thing we all have in common… Celebrate it every day.”-Winston Churchill
One of the most popular risk management strategies is diversification. This technique mingles a wide array of investments in the same portfolio. A portfolio that is properly diversified includes a wide array of asset types in hopes of limiting exposure to a single asset. One of the most popular risk management strategies is diversification. This technique mingles a wide array of investments in the same portfolio. A portfolio that is properly diversified includes a wide array of asset types in hopes of limiting exposure to a single asset.
The logic behind this strategy is that a portfolio built of different types of assets could produce higher long-term returns while maximizing the potential of a single asset to the portfolio it’s being traded in.
Getting to know Diversification
Academic models have demonstrated that having a diversified portfolio of 25-30 stocks is the best and most cost-effective way to maximize potential.
The goal of diversification is to realize the potential of a portfolio. This way, the positive performance of certain assets cancels out the non-ideal performance of others in the same portfolio. It should be noted that diversification only works if the assets in the portfolio react differently, usually in opposing directions, to market events.
There are many different strategies to diversify successfully. Among them involves mixing and matching asset classes that usually perform inversely to specific asset classes. For example, increased interest rates usually hurt bond prices. However, lower interest rates could cause a housing boom that could result in a higher demand for commodities used for construction like copper. So theoretically, a lower US dollar could drive copper higher. Aside from construction metals, volatility in fiat currencies like the US dollar is traditionally good for precious metals like gold. That’s why many traders will often trade both assets in the same portfolio as a means to maximise potential in case one of those securities doesn’t perform as well as we hoped it would.