The concept of diversification is to create a portfolio that includes multiple investments; in order to reduce risks. So an investor will want to invest in numerous companies to reduce the risk than in a single company; just in case that company stock suffers a downturn. Basically, it can be summed up as “don’t put all your eggs in one basket.” Furthermore, the best way to reduce an investor risk is to have a combination of bonds, stocks, and cash because stocks are much riskier than bonds. Diversification can help any investor manage their risk while avoiding costly mistakes by adopting a risk level that they can live with. For example, when a portfolio is diversified it is done through the asset allocation which is bonds and stocks; in turn, the investors may want to be aggressive to create 80 percent stocks and 20 percent bonds; while others may want to be more conservative and prefer a 20 percent stock and 80 percent bonds. Also, a small portion of an investor’s asset can be in the form of cash or short-term money market securities. Therefore, creating an investment mix based on the investor goal, level of risk they are willing to take, financial situation, the timeline of where you are in life, and diversification will help an investor limit losses and capture gains.
However, in addition to stocks and bonds investors have a host of other alternatives opportunities such as real estates, equities, fixed income, investment trusts and hedge funds which can provide diversification. They may not necessarily move in line with the tradition of the financial markets. Also, it depends on the investor comfort level with the different risk levels and their goals. In other words, if the money is needed sooner than for example, ten years, then it would be wiser to invest more in bonds. Especially, US Treasury and savings bonds are guaranteed by the Federal Government. Then the percentage to invest in each class of assets would depend on the investor goals.
On the contrary, an investor must look at five types of constraints before deciding on what assets to invest in. Firstly, liquidity constraints are the ability to turn the assets invested into cash within a short time period, for instance, the money maybe immediately needed to pay tuition or medical bills, etc. Secondly, there is the time constraint, in which a portfolio is expected to give a guaranteed return over a specified time period. For instance, if that money is needed before then, the investor should determine the portion to invest in short or long-term assets. Thirdly, tax constraints will depend on the various tax classes on how, when and if the capital gains of the different assets are taxed. Generally, bonds and or equities are often taxed at a lower rate than other income such as dividends. Also, an investor can opt to increase an IRA contribution and will only be taxed after retirement when the money is withdrawn. Then for legal constraints, mainly investors need to know when they can withdraw from their investments or how much can be withdrawn early for instances, and also if there are hidden fees if this happens. Finally, in the unique circumstances category, investors have to know if the companies they are investing in a manufacturer or distribute tobacco, alcohol, defense products, firearm or environmentally harmful products. An example would be, an investor who is an environmentalist may only want to invest in individual companies that do not pollute the environment, and this information should be disclosed.