The word “diversification” is thrown around a lot in finance.
Self-directed individual investors are urged to diversify their investment portfolios to reduce risk. But what exactly that means, and why “diversification” is considered common sense deserves some explanation.
Diversification is a technique in investment that seeks to reduce risk by delegating investment funds over a larger range of industries, financial instruments, and oftentimes other categories. In this article, we will cover:
You should diversify your portfolio to reduce its overall risk.
Investing in a more diverse range of securities serves to minimize your losses.
If, for example, you are invested entirely in just one company, what happens if that company has a serious downturn or declares bankruptcy? Well, you’re finished investing is what!
Diversification means more than just that, however. Everyone understands this basic explanation of why you shouldn’t “place all your eggs in one basket”. But most financial advisors would advise you to diversify in terms of:
There are good reasons for this. For example, on the industry level, how much better is it to be invested in 20 oil companies versus one oil company during an oil crash? It’s certainly better, but you can still be sure your oil-soaked portfolio will suffer for it.
This may be a stereotypical example, but it’s still one that makes a clear point. Similar examples could be made of people who were overinvested in airlines’ stocks when covid-19 hit.
If, however, only one or two of the 20 stocks in your portfolio were an airline’s when the crash occurred, you would not be happy, but you wouldn’t be ruined.
So, investing in good companies in different sectors is the only way to avoid suffering the same fate as someone who made one of the above mistakes.
It’s important to remember all of the above in the context of multiple levels. Depending on your strategy, diversification may be important to consider at any mix of:
In terms of the types of securities you invest in, an appropriate level of diversification can further deter your risk.
For example, adding treasury bonds to an all-stock portfolio can greatly reduce the overall risk to your portfolio. A mix of asset classes brings greater diversification and thus less risk to your portfolio.
Let’s take the example of stock investment.
It’s 2018 and you’re very familiar with the airline industry. But being a generally knowledgeable investor, you know that sector-wide trends can make or break your entire portfolio.
That level of risk is simply unacceptable. So, to protect yourself from negative changes in the airline industry, you invest in other transportation stocks. Ideally, this pattern expands into new industries entirely. At some point, if one or two entire sectors collapse, your portfolio can absorb the blow.
As stated above, diversification can be applied by:
We can also add:
Let’s break this down.
This is the most basic and important level of diversification.
You don’t want to bet your whole future on just a few companies. Companies come and go. Try finding a list of blue-chip stocks for the earliest years of the new millennium. Some are still around, but you may be surprised to find out how many of these “safe”, “elite” companies went bust.
The point here is that there isn’t one (or two, or three) safe company that you should bet all your money on. Anything can happen, and history provides many examples.
Some consider it ideal to diversify your portfolio with assets in different traditional asset classes.
The argument is essentially that changes in economic conditions affect different asset classes very differently. For example, there is real evidence that, for example, equity and gold markets move in very different directions than stocks under many circumstances.
In addition, asset classes contain different levels of risk. Treasury Bonds come with government guarantees. Publicly traded companies come with no guarantees at all.
Companies in a single industry often perform very differently.
Of course, individual companies’ managerial competence is of the utmost importance. However, economic trends can often be sweeping, affecting entire industries.
A well-managed company in a single industry will do better during an industry-wide downturn than a poorly-managed alternative. But an investor that has only invested in this one industry will suffer regardless.
This level of diversification shouldn’t be viewed as a necessity.
In fact, it’s prudent to be very cautious when approaching foreign markets. Take your time to understand them thoroughly first. If you do invest in developing and emerging markets, the typical experience is a much higher level of risk, but much faster growth for your winners.
However, that assumes that you are very careful and methodical.
Adding strategic and alternative asset diversification can make your portfolio more complicated.
But if you have the time and the knowledge, there’s nothing stopping you from:
An extreme example of the former would be having one account where you engage in long-term value investing and another where you engage in day trading. Less extreme examples would include two strategies that more closely resemble each other.
A simple example of the latter would be investing 1% of your portfolio into Bitcoin to take on more risk but potentially benefit from the crypto’s extremely erratic price changes.
These kinds of choices can be very risky and/or complicated, so we suggest engaging in thorough research if you’re considering either.
Portfolio diversification is as simple as expanding the process by which you select your investments.
It reduces your overall risk, as a wider range of assets implies a lower amount of risk. You can expand your process in terms of individual assets, industries, asset classes, and even alternative assets or foreign markets.
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