Three Types of Portfolio Diversification You Need To Know
Investing is all about meeting your return goals without taking unnecessary risks. The number one strategy for managing risks is through diversification. There are three types of diversification that you can apply to your portfolio
There are five types of asset classes that you can utilize to diversify your portfolio.
A great diversification strategy is to reduce correlated risks. The best way I can explain this is with an example. Let’s say you have some gold coins that you purchased, you own stock in mining companies that specialize in gold, and you have purchased the gold ETF. Your entire portfolio is now based on how well gold does. If gold should decrease in value the entire value of portfolio will decline. This is why you need to own all different types of stocks and bonds. You should own a lot of different companies if you are managing your own stocks that operate in different industries. A lot of mutual funds will handle this for you if you don’t want to be a hands on investor.
The importance of this type of diversification was shown during the recession and financial collapse from 2008-2009. For simple example let’s look at the insurance industry and hurricane Katrina. You have insurance agents who sold flood insurance to homeowners and there were a handful of insurance companies that guaranteed payments for these policies if there should be a flood. Lloyd’s of London was insuring hundreds if not thousands of residential properties in the New Orleans area. Then when Katrina hit the company almost went bankrupt paying out all these claims as the issuer on all the policies.
For a working example this means you don’t want securities tied to the same entity. Buying Coca-Cola stocks and bonds is not a great idea. You should purchase one or the other.
As you grow richer you might also want to start thinking about your geographic exposure. Having a portfolio built of all American companies might not be a good idea because if America were to go back into a recession your entire portfolio would decline. In relation to geographic exposure you may also want to consider currency exposure. If you invested in companies that operate in Europe for example the profits of those companies would depend on the strength of the Euro.
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About Shaun Archer Tatum Shaun works in corporate finance in New York City. He has done financial consulting for several start-ups and has worked at several Fortune 500 companies. He has contributed several finance/investing articles on Seeking Alpha which have been published on Yahoo! Finance.