Understanding Diversification

By: Eric Gursky

With a down economy many investors in recent months have learned how valuable it is or was to have a diversified portfolio. Those whose were solely invested in equity or were seduced by the high returns of Bernie Madoff lost most if not all their money in the market. Portfolio diversification is an easy way to reduce the risk of your portfolio by spreading the risk throughout many financial instruments. When diversifying there are many factors that come into play which are different for every investors.
The two main types of diversification are:

Vertical diversification: spreads your money between different types of assets. Cash, government bonds, corporate bonds, property and shares can each be expected to behave slightly differently, and so potentially produce different returns, as circumstances change.

Horizontal diversification: is when you hold different instances of the same asset class. This time you’re trying to reduce localised company or sector-specific risks, particularly with shares.

Once you have figured out which type of diversification you wish to follow you also have to understand time horizon and risk tolerance because they place a critical role into which assets work best.

Time Horizon - Your time horizon is the expected number of months, years, or decades you will be investing to achieve a particular financial goal. An investor with a longer time horizon may feel more comfortable taking on a riskier, or more volatile, investment because he or she can wait out slow economic cycles and the inevitable ups and downs of our markets. By contrast, an investor saving up for a teenager's college education would likely take on less risk because he or she has a shorter time horizon.

Risk Tolerance - Risk tolerance is your ability and willingness to lose some or all of your original investment in exchange for greater potential returns. An aggressive investor, or one with a high-risk tolerance, is more likely to risk losing money in order to get better results. A conservative investor, or one with a low-risk tolerance, tends to favor investments that will preserve his or her original investment.

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