Diversification: How Diversified Allocation Reduces Portfolio Risk
Diversification is a strategy of allocating funds across different assets, regions, industries, or investment vehicles. It aims to reduce the impact of any single holding on the overall portfolio, but cannot eliminate the risk of loss and may also limit the upside potential.
The Basic Concept of Diversification
Diversification involves spreading funds across different assets or asset classes, such as stocks, bonds, commodities, and cryptocurrencies. Its purpose is not to guarantee profits, but to prevent the portfolio from becoming overly dependent on a single asset. When some assets perform poorly, stronger performance from others may cushion losses and make long-term returns relatively steadier.
Why Correlation Matters
Assessing whether diversification is effective requires looking beyond the number of holdings to the correlation between assets. Correlation reflects the degree to which different asset prices move together: assets that move in opposite directions or have weak co-movement generally help diversify risk more effectively. If multiple assets fluctuate highly in the same direction, the portfolio may still behave like a single position when facing market changes.
Common Approaches and Limitations
Investors can select assets with different purposes within the same asset class, or allocate across asset classes, countries and regions, industry sectors, and company sizes. Index funds or exchange-traded funds can be used to hold a basket of securities. Although diversification can reduce the likelihood of major losses, spreading holdings may also limit the upside from a single high-return asset.
Original Tutorial
https://www.binance.com/zh-CN/academy/glossary/diversification
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