/Lydia Wanjiru/ -- Diversification is a risk management strategy and a key parameter to consider before you invest in stocks. It is a technique that plays a major role in mitigating risks by allocating investments among various securities in industries, geographical regions and more. Diversification mitigates unsystematic risk events in a portfolio. It is basically compared to “not putting all your eggs in one basket” and aims to maximize returns by investing in different stocks that would react differently to the same event. US stocks are exposed to market and economic forces in the U.S and they will react differently when exposed to the same events. To build a diversified portfolio, you need to know the various types of diversification available. Here are 6 types of diversification of your portfolio:
1. Individual company diversification
You can diversify your portfolio by buying a mix of individual company’s assets. This helps to hedge you against a potential loss should one company stock fail or reduce in value. Investing in a variety of stocks issued by a company can hedge you against the risk of volatility or losing your capital in the event one particular stock performs poorly. For example, you can achieve diversification through investing in different index funds.
2. Industry diversification
You can also diversify by buying stocks across multiple industries in the economy. This can help you to mitigate the risk of losing your capital if a company fails or performs poorly. Different companies can react differently to the same event and the more diversified your portfolio is, the safer you are if one is impacted negatively.
3. Asset class diversification
Asset class diversification involves buying across different classes of assets such as equity, debt, and commodities. These include government bonds, treasury bills, shares, mutual funds, Exchange Traded Funds (ETFs), real estate investments trusts (REITs) gold, cash among others. Investment in a portfolio can also include options, derivates like futures and forwards and physical investments like land & real estate. When you combine a variety of assets, you reduce the overall risk of an investment in a portfolio.
4. Strategy diversification
You can also derive superior returns over time compared to a market-cap weighted index if you employ different strategies also called risk factors or smart beta. A mix of these factors which include value, small-cap funds, large-cap funds, momentum, high quality and more can help reduce the risk exposure by a significant percentage.
5. Geographic and region-based diversification
You can diversify your portfolio internationally if you buy a mix of stocks across different countries and cities in the world. Foreign stock investments can help you to take advantage of currency fluctuations. This also provides a cushion of protection against losses faced by one country’s’ economic downturn.
6. Time-based diversification
It is also wise to consider timing when investing in stocks. This involves using dollar-cost averaging which hedges you against poor timing investments decisions and investments. This can involve choosing stocks based on long-term, medium-term and short-term investment strategy.