The concept of diversification is fairly simple, and it can be explained through the phrase: “Don’t put all your eggs in one basket”.
Diversification brings many benefits, especially for less seasoned investors who are seeking to protect their capital from significant losses.
When it comes to investments in financial assets, diversification can be achieved by incorporating various asset classes into a single portfolio. Each of these assets will usually carry a certain risk and they will also generate a certain return.
The introduction of cryptocurrencies has provided an interesting new asset class that investors can bring into their portfolios. Investors could, for example, trade Ripple, Bitcoin, Ethereum, Litecoin, or any other cryptocurrency, using a small percentage of their total funds in what are usually high-risk/high-reward operations to further diversify or even increase their portfolio returns.
In this regard, investors can achieve optimal diversification by following an approach known as modern portfolio theory, which states that there’s a certain combination of assets that achieves the highest possible return at the lowest possible risk.
In practice, this can be accomplished by analyzing all the available asset classes including bonds, stocks, cryptocurrencies, fiat currencies, and derivatives. Each of these assets carries a particular risk and yields a certain return and an investor’s goal is to determine how much of each should be incorporated into the portfolio to produce the highest possible return, at the lowest possible risk.
The true importance of diversification is its capacity to cushion the impact of a significant drop in the value of one single asset, which would cause a disastrous outcome in a portfolio that relies on that singular asset.
Meanwhile, a diversified portfolio can offset losses in certain asset classes by using the gains in others and this concept can be further extended beyond the scope of financial assets, to be applied to income sources, jobs, and businesses.
Diversifying your Investments
Most investors rely on two asset classes to diversify their portfolios: stocks and bonds. Even though these are by far the most popular asset classes in the financial world, there are also other financial instruments you could take into account when you build your investment portfolio.
Some of these other “less popular” alternatives include:
- Foreign currencies.
- Derivatives (options, futures, CFDs, etc).
The percentage the investor decides to put into each asset class is usually determined by his risk profile and financial goals, while the actual financial instruments bought for each portion of the portfolio can be determined by analyzing the fundamentals behind each available alternative.
Income Diversification
The concept of diversification can be expanded further to the income sources an individual has.
A person that relies 100% on the income obtained from his regular job is exposed to certain risks that may endanger his financial stability such as a potential illness or a partial or permanent disability.
There are many ways you can diversify your income sources, and these are some of the most common alternatives:
- Start a small business that produces extra income.
- Invest money into fixed-income securities that produce some extra money each month.
- Work as a freelancer to diversify the source of your income from one single employer to multiple ones.
Diversification in Business
Furthermore, diversification is also crucial in the business world, as one single product or service may eventually fail to produce good results, as all products have a life cycle that eventually leads to their death.
In this regard, successful businesses continuously invest in research and development to design and launch new products, while they also expand their scope to incorporate alternatives that serve new markets.
By doing this, a business ensures that negative results from one product or service will not endanger the whole company’s financial stability.
As an example, Apple, the popular tech company that invented the iPod and the iPhone, has been concentrating significant efforts and resources towards the development of other revenue segments such as services (iTunes) and cloud solutions (iCloud) to further diversify its revenue streams. This would allow the company to be less affected by the potential swings in the demand of its consumer electronic devices.
Bottom Line
The concept of diversification is usually seen as a cornerstone of successful investment portfolios. Even though the theories that study this matter are usually applicable to the financial and investment field, the essence of this concept can also be incorporated to other aspects of an individual and business’ finances.
Therefore, achieving optimal diversification in various areas should result in a more stable and reliable financial outcome, even during times of financial distress.
