Diversified portfolios greatly reduce risk while smoothing investment returns by including many securities across a wide range of industries. This allows investors to participate in a wide variety of investment opportunities while reducing the risk of large losses due to any one security.
What Are the Components of a Diversified Portfolio?
A diversified portfolio is a collection of asset classes. Asset classes refer to distinctly different types of securities -- such as stocks, bonds, commodities, international investments, cash and real estate. The purpose of the diversified portfolio should be to offer maximum return while minimizing the overall risk of the portfolio.
Asset Classes Make a Diversified Portfolio
Common asset classes are stocks, bonds, commodities and currencies. Asset classes are a unique group of stocks that have common properties. Stocks and preferred stocks can be considered different classes but they are not as diversified as a combination of stocks and foreign currencies.
Diversify Within Each Asset Class
Owning a stock portfolio is better than owning a single stock. Owning a stock and bond fund adds another new asset class. Adding a third asset class, commodity exchange traded funds, further spreads risk and smoothes returns.
A Diversified Portfolio is a Core Principle of Investing
Investing is not being smarter than the market. It is about riding the market trends as profitably as possible under a variety of circumstances. Diversified portfolios help ride out market uncertainty.
Indices are Diversified Portfolios
You can buy an index fund of stocks, bonds, or other asset classes that is a proportionate sample of all the securities in that index. Exchange traded funds are low cost replicas of many asset classes. Purchased together, a cost-effective diversified portfolio of many asset classes can be assembled.
The Alternatives to a Diversified Portfolio
Owning securities that are very similar or highly correlated provides irregular returns and high risk. Investors suddenly needing to convert their asset to cash at inopportune times will have no choice but to accept the current market price.