In the context of financial markets, diversification refers to allocating capital to different financial instruments within and across asset classes. The main goal is to reduce the overall risks that may arise from holding a single asset class, such as a stock, bond, commodity, or cryptocurrency.
The idea behind the diversification strategy is that a portfolio made of a wide variety of assets is more likely to give better long-term returns, while also reducing the probability of significant losses. Diversification can be achieved within a single asset class (e.g., investing in different types of cryptocurrencies) or across various asset classes (e.g., investing in cryptocurrencies, stocks, and commodities).
In general, a diversified portfolio will have a smoother variation in regards to its net value. Mainly because the assets that present a positive performance tend to neutralize the ones with negative returns. As such, it is important to consider the correlation between the assets that make up an investment portfolio. For instance, if a portfolio is made up of highly correlated cryptocurrencies, it will react to market influences much like a single-asset bag. Negatively correlated assets are more beneficial in terms of diversification because they respond differently to market forces and tend to move in opposite directions.
Diversification by Asset Class
Fund managers and investors often diversify their investments across asset classes and determine what percentages of the portfolio to allocate to each. Classes can include:
- Stocks—shares or equity in a publicly traded company
- Bonds—government and corporate fixed-income debt instruments
- Real estate—land, buildings, natural resources, agriculture, livestock, and water and mineral deposits
- Exchange-traded funds (ETFs)—a marketable basket of securities that follow an index, commodity, or sector
- Commodities—basic goods necessary for the production of other products or services
- Cash and short-term cash-equivalents (CCE)—Treasury bills, certificate of deposit (CD), money market vehicles, and other short-term, low-risk investments