Foster Swiss — What is the role of diversification in Investing?
Spreading your investments among different asset classes limits your exposure to any one asset type. This is known as diversification. Over time, this practice should assist in lowering the volatility of your portfolio. To put it another way, it lowers risks, aids in enhancing long-term portfolio performance, and evens out returns. Let’s understand the role of diversification in investment with Foster Swiss experts.
Define diversification
Definition of diversification
The idea of “not putting all your eggs in one basket” is a common justification for diversification. You have more baskets if you diversify your investments. You won’t break every egg if there are eggs in different baskets. Diversification is the process of choosing and allocating a portfolio’s investment assets in a way that minimizes exposure to risk, according to academic definitions.
Furthermore, Julia Spina, a quantitative finance researcher at TastyTrade claims “Every financial instrument is subject to some sort of risk factors, and a portfolio that is overly concentrated in a single instrument tends to be much more sensitive to those risk factors and more volatile as a result,”. Investors find it more difficult to form trustworthy profit expectations the more erratic a portfolio’s returns are.
Advantages of diversification
Diversification’s merits Correlation and variance & standard deviation are two academic ideas at the core of diversification. Let’s explore these:
Correlation gauges the strength and direction of the relationship between the returns on two assets. A correlation of 1.0 indicates perfect movement in one direction for both assets, while a correlation of -1.0 indicates complete movement in the other direction for both assets. A correlation of 0 suggests two assets move completely independently of each other.
The historical range that an asset has historically fluctuated, on average, around its expected return is measured by the standard deviation and variance. For instance, if a stock has a CAGR (compound average growth rate) of 7 percent per year, but it has a high variance (and therefore a high standard deviation, which is the square root of variance), this indicates that its return varies greatly and 7 percent might not be a realistic expectation in any given year.
Final words!
As a general rule, a diversified portfolio of uncorrelated (between 0.20 and 0.50) and volatile (high standard deviation) assets with positive expected returns will produce a better risk-return profile than an undiversified portfolio consisting of a single asset. If you want any further information about this subject, don’t hesitate to contact Foster Swiss experts.
