What is diversification and how does it work?

Would you save one year’s worth of your salary to buy a flower? There was a time when many people would.

During the Dutch Golden Age people were amazed with the ordinary tulip bulb. At the time, the flower was considered a thing of rare beauty. Everyone had to have one. Some reports claim that at the height of the excitement a single tulip bulb cost ten times the average annual salary of a craftsman. Financial markets sprung up around the flower. Futures markets emerged. By 1636 the mania reached a peak. The plague was the only thing that could stop the bubble. Eventually prices crashed and investors were crushed.

What could have avoided these lost fortunes? Diversification.

Diversification is the oldest and most important strategy for investors. When you spread your money across many different investments you are diversifying. The idea is simple: if one investment drops (or crashes) you don’t lose everything.

Investors put this principle into place by investing in different stocks with mutual funds. These funds allow investors to purchase a single share that gives them exposure to hundreds of companies. However, this style often doesn’t offer enough diversification.

Investors often choose to go further and diversify among asset classes. This method means investing not only in various stocks but also different kinds of investments like bonds or even commodities like gold and other precious metals. This method is called asset class allocation. For a long time this approach served investors well. Then, the financial crisis hit.

In those difficult years investors discovered that even asset class allocation could fail. Why? During times of crisis the correlation among these different classes can rise. “During the two significant bear markets of the last 10 years—correlations between many individual investments and even asset classes spiked,” according to BlackRock.

What’s the solution? Alternative investments.

More investors are learning that they need to broaden their exposure to alternative investments to help weather uncertain markets. Examples of alternative investments include currency, short-trading and of course alternative lending.

Investment opportunities offered by P2P lending have lower correlations to traditional assets like stocks and bonds because the influencing factors are different. As a result, investors can continue to seek high returns while diversifying risk across assets that move in different ways. The value of alternative investments is seen in the growth of a hypothetical $10,000 investment from June of 1997 to June of 2012. A portfolio including alternative investments would grow to nearly $60,000 while a portfolio of 60% stocks and 40% bonds would reach only approximately $25,000.

In today’s world economies are more connected than ever. For this reason, investors need to rethink outdated strategies of relying on just stocks and bonds.

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