Diversification

What is Diversification?

Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio. A diversified portfolio contains a mix of distinct asset types and investment vehicles in an attempt at limiting exposure to any single asset or risk. The rationale behind this technique is that a portfolio constructed of different kinds of assets will, on average, yield higher long-term returns and lower the risk of any individual holding or security.

The Money Pouch diversifies with a mix of:

• Stock ETFs
• Bond ETFs
• Gold ETFs

The Basics of Diversification

Diversification strives to smooth out company specific events in a portfolio, so the positive performance of some investments neutralizes the negative performance of others.

In this way, diversification attemps to lower the risk of investing.

The benefits of diversification hold only if the securities in the portfolio are not perfectly correlated. Equities, bonds and gold are not perfectly correlation. They may not alway increase or decrease in the same direction. This smooths out volatility.

Studies and mathematical models have shown that maintaining a well-diversified portfolio of 25 to 30 stocks yields the most cost-effective level of risk reduction. Many equity exchange traded funds (ETFs) hold a well-diversified basket of stocks.

KEY TAKEAWAYS

• Diversification is a strategy that mixes a wide variety of investments within a portfolio.
• Portfolio holdings can be diversified across asset classes and within classes, as well as by geographical location, for example, by investing in both domestic and overseas markets.
• Diversification limits portfolio risk but can also reduce performance, at least in the short term. This adds a layer of protection to your portfolio.

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:

• Stock ETFs are exchange-traded funds (ETFs) that track a particular set of equities, similar to an index. They trade just as a normal stock would on an exchange, but unlike a mutual fund, prices adjust throughout the day rather than at market close.
• Bond ETFs are exchange-traded funds (ETFs) that exclusively invests in bonds. These are similar to bond mutual funds because they hold a portfolio of bonds with different particular strategies, from U.S. Treasuries to high yields, and holding periods, between long-term and short-term. Prices adjust throughout the day rather than at market close.
• Gold ETFs are exhange-traded funds (ETFs) that provide investors with a low-cost, diversified alternative that invests in gold-backed assets rather than the physical commodity.

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