Diversification is a form of hedging and is key to a balanced portfolio. A mixture of diverse securities minimizes the unsystematic risk associated with allocating capital to a single stock or sector and reduces the effects of market volatility.
Diversification has shown the ability to produce more consistent returns over long time periods. As with any form of hedging, diversification comes at a compromise of total profit potential.
Diversification allows investors to construct a portfolio that maximizes return while limiting risk by varying asset allocation between domestic and international equities, bonds, money markets, commodities, and cash to help reduce the risk of individual security price fluctuations and maximize overall portfolio performance.
Because different asset classes tend to perform better in different parts of the economic cycle, diversification provides exposure to assets that may outperform the returns of underperforming assets to bolster the overall portfolio.
Investors may use beta-weighting, R-squared correlation, or delta-neutral strategies to measure their portfolio’s correlation to major index benchmarks to forecast how the portfolio will perform and react to changes in market conditions.
Diversification can help lower the variance of a portfolio and help create a smoother equity curve over time. In theory, diversification works because some assets will perform well while others underperform. Research has shown that when volatility increases, investments tend to move in sync with one another, thus rendering diversification less effective when markets crash.