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What is investment diversification?
Reporting on Investopedia, Investment diversification is a technique that is carried out in order to reduce the risks that exist in your investments, by allocating your investments in various existing instruments such as finance, industry, commodities, and other categories. This will aim to maximize returns by investing in different areas so that each instrument will react differently to the same event.
Most investment professionals agree that, while it doesn't guarantee losses, at least diversification is the most important component of achieving a long-term financial goal while minimizing the risks. Therefore, it can be seen why diversification is right to do and how diversification can be achieved in your portfolio.
How Investment Diversification Works
After knowing what investment diversification itself is, this time we will discuss how investment diversification works. For those of you who want to animalize the level of loss you have, you can apply the method below to your investment funds.Understand Risk Tolerance
The first step you can take to diversify your investment is to understand and recognize risk tolerance itself. The most common mistake made by beginners in the world of investment is that they only think about the profits without thinking about how to measure the risk. Before you choose several products or instruments in investment, you must understand and also recognize in advance how big your own risk tolerance level is. Which is how much of your ability to be able to face an investment risk that comes suddenly.
For example, when the value of a stock is experiencing a drastic decline, most of the beginner investors will immediately panic by selling it without considering and doing a proper analysis. By having this appropriate risk tolerance, investors will not be rash in acting when an investment risk occurs that is considered unpleasant later.
Determining the Type of Investment
Next is to choose the right type of investment and also the most suitable for the conditions we have and existing needs. Preferably, the type of investment taken must be in accordance with the level of risk tolerance owned by oneself. For example, a stock investment that has a fairly large dividend but also has a high risk. If you are not able to face the risk, then you should choose another type of investment with lower risk such as gold, for example.
Determining Investment Objectives
Furthermore, what is no less important in diversifying is to determine what can be the goal in making investments. If the goal is to increase wealth, then making a long-term investment is the right choice. But if your goal is only to get instant profits, then you can choose short-term investments. Examples in making long-term investments, for example, such as stocks and gold, while for short-term investments, for example, such as deposits or bonds.
Product Diversification
The next diversification step that can be done is by investing funds in different products even though the type of investment is the same. For example, if you are a stock, then you can buy shares in several other companies not only in one business. That way, when the stock price in one company is declining, investors can still have a chance to make a profit on other stocks.
Types of Investment Diversification
After knowing how this investment diversification works, this time you will find out what are the types of investment diversification itself. These types are divided into two, vertical and horizontal, for a further understanding of the type of investment diversification is, you can understand through the following explanation.Vertical Diversification
Vertical diversification is a strategy that creates products with different levels of usability, but can still complement or replace each other. There are several examples of product diversification that are vertical, namely kitchen sets that are sold separately, vehicle parts, or the production of cow's milk and also soy milk formula in one company, and so on. Or as a simple example, for example, a cattle farming company that not only sells beef, but the company can develop its business in a more specific direction, such as the production of a cowhide which is then passed down the product into materials to a special company that is making shoes.Horizontal Diversification
Diversity created by horizontal diversification is diversification carried out by dividing businesses to the side. For example, from a leather company that will produce a shoe, bag, or belt. The processed cowhide product can be called a product of horizontal diversification. This is a strategy to create a variety of products of the same type, but are differentiated in terms of brand, size, and target market. This diversification strategy is the most diversification to be carried out in Indonesia. Some examples for the most horizontal product diversification are instant noodles, medicines, snack foods, body soap, shampoo and conditioner, and so on.How to Diversify Your Investment
Furthermore, there are ways you can do to diversify this investment. You can apply the method below when diversifying yourself. How to diversify your investments is:Determining Correlation
This diversified portfolio will help the whole of your investments to be able to absorb every risk from an existing financial disorder, by providing a good balance to your own savings plan. This diversification is not limited to only the type of investment instrument or class of securities, it can also extend to each of these securities. You can invest in different industries such as bonds, industries, or tenors. For example, you can't put all your investments in the pharmaceutical sector, even though it is the sector that is performing best in the midst of the current pandemic among other sectors. Of course, there is still diversification in other sectors that are developing, such as technology in education and information technology. Even if you already have many different types of investments, then if all the trends are going up or down together, then your portfolio is not properly diversified. For example, high-yield bonds will often have a positive correlation with stock assets. Therefore, a portfolio that consists entirely of bonds and high-yield stocks will not be well diversified.Diversification Between Asset Classes
This investment instrument offers several asset classes that you can choose from, including:- Equity (shares)
- Fixed income investments (bonds)
- Cash and cash equivalents
- Real assets including property and commodities
Diversity in Asset Classes
There are various asset classes that you can choose to use as investment assets. Here are some ways you can diversify into asset classes.- Industry. If you choose to invest in energy stocks, then you can consider adding sectors such as technology, biotech, utilities, retail, and other industries to your portfolio.
- Fixed income (bond) investments. You can look for bonds with different maturity times also from different issuers to be able to minimize losses, including to the US government and companies.
- Funds. While there are some funds that track the stock market in an overall way (commonly known as index funds), others will focus on the market segment on a particular stock. Therefore, if your goal is to diversify, you can check what stocks will be invested in your funds to be able to ensure that your investment is not too exposed to one area or another.
Diversification by Location
Asset classes are not the only way to diversify. So you should consider a location and also global exposure. For example, if you only own one security in US stocks, then your entire portfolio will be subject to the specific risks that are in the US. While these foreign stocks and bonds can increase the diversification of your portfolio, they will still be subject to country-specific risks, such as foreign taxes, currency risk, or risks associated with political and economic developments.Explore Alternative Investments
If you're looking for additional diversification, then there are assets such as Real Estate Investment Trusts (REITs) and commodities are potential options.- REIT works by operating property, such as office buildings, shopping centers or apartment buildings. Owning shares in REITs means that it will give you an opportunity to be able to receive a portion of the income from the business itself in the form of dividends. In addition, REITs are not strongly correlated with stocks or bonds.
- Commodity investment is an investment in the form of physical goods, ranging from gold commodities to natural gas, agricultural products such as wheat and even livestock. You can buy the commodity directly or through commodities in the form of funds.
Rebalance Your Portfolio Regularly
Even the most diverse portfolios still need to be rebalanced. Over time, certain investments will inevitably gain value, while others will lose them. The Rebalancing technique is a way to negotiate between risk and reward that can help your portfolio stay on track amid the ups and downs in the market. There are certain situations that may trigger this rebalancing, including market volatility and major events.Consider Risk Tolerance
Your tolerance for risk can also affect your approach to diversification. Generally, the longer your tolerance period, the more you can overcome losses in the short term to potentially capture profits in the long term.- Aggressive investors, who will generally have a horizon in a period of 30 years or more. With this flexibility, they will have a higher risk tolerance and be able to allocate 90 percent of their money to stocks and only 10 percent to a bond.
- Moderate investors, for whom they will have about 20 years before they will need money, will generally allocate a lower percentage to a stock than an aggressive investor. For example, they will probably have 70 percent of their funds in stocks and 30 percent in bonds.
- Conservative investors, those who have a tolerance for small risks or will need their money in a period of 10 years or less, can make a 50/50 balance between stocks and bonds.
