The Importance of Diversification

What Is Diversification in Investing?

Diversification is a technique that reduces risk by allocating investments across various financial instruments, industries, and other categories. It aims to maximize returns by investing in different areas that would each react differently to the same event.

Most investment professionals agree that, although it does not guarantee against loss, diversification is the most important component of reaching long-range financial goals while minimizing risk. Here, we look at why this is true and how to accomplish diversification in your portfolio.

Key Takeaways

  • Diversification reduces risk by investing in vehicles that span different financial instruments, industries, and other categories.
  • Unsystematic risk can be mitigated through diversification while systemic or market risk is generally unavoidable.
  • Balancing a diversified portfolio may be complicated and expensive, and it may come with lower rewards because the risk is mitigated.

Understanding Diversification in Investing

Let's say you have a portfolio that only has airline stocks. Share prices will drop following any bad news, such as an indefinite pilot strike that will ultimately cancel flights. This means your portfolio will experience a noticeable drop in value.

You can counterbalance these stocks with a few railway stocks, so only part of your portfolio will be affected. In fact, there is a very good chance that these stock prices will rise, as passengers look for alternative modes of transportation.

You could diversify even further because of the risks associated with these companies. That's because anything that affects travel will hurt both industries. Statisticians may say that rail and air stocks have a strong correlation. This means you should diversify across the board—different industries as well as different types of companies. The more uncorrelated your stocks are, the better.

By diversifying, you're making sure you don't put all your eggs in one basket.

Be sure to diversify among different asset classes, too. Different assets such as bonds and stocks don't react the same way to adverse events. A combination of asset classes like stocks and bonds will reduce your portfolio's sensitivity to market swings because they move in opposite directions. So if you diversify, unpleasant movements in one will be offset by positive results in another.

And don't forget location, location, location. Look for opportunities beyond your own geographical borders. After all, volatility in the United States may not affect stocks and bonds in Europe, so investing in that part of the world may minimize and offset the risks of investing at home.

How Many Stocks You Should Have

Obviously, owning five stocks is better than owning one, but there comes a point when adding more stocks to your portfolio ceases to make a difference. There is a debate over how many stocks are needed to reduce risk while maintaining a high return. The most conventional view argues that an investor can achieve optimal diversification with only 15 to 20 stocks spread across various industries.

Different Types of Risk

Investors confront two main types of risk when they invest. The first is known as systematic or market risk. This type of risk is associated with every company. Common causes include inflation rates, exchange rates, political instability, war, and interest rates. This category of risk is not specific to any company or industry, and it cannot be eliminated or reduced through diversification. It is a form of risk that all investors must accept.

Systematic risk affects the market in its entirety, not just one particular investment vehicle or industry.

The second type of risk is diversifiable or unsystematic. This risk is specific to a company, industry, market, economy, or country. The most common sources of unsystematic risk are business risk and financial risk. Because it is diversifiable, investors can reduce their exposure through diversification. Thus, the aim is to invest in various assets so they will not all be affected the same way by market events.

Problems with Diversification

Professionals are always touting the importance of diversification but there are some downsides to this strategy. First, it may be somewhat cumbersome managing a diverse portfolio, especially if you have multiple holdings and investments.

Diversification can also be expensive. Not all investment vehicles cost the same, so buying and selling will affect your bottom line—from transaction fees to brokerage charges. And since higher risk comes with higher rewards, you may end up limiting your returns.

Next, consider how complicated it can be. For instance, many synthetic investment products have been created to accommodate investors' risk tolerance levels. These products are often complex and aren't meant for beginners or small investors. Those with limited investment experience and financial backing should consider purchasing bonds to diversify against stock market risk.

Unfortunately, even the best analysis of a company and its financial statements cannot guarantee it won't be a losing investment. Diversification won't prevent a loss, but it can reduce the impact of fraud and bad information on your portfolio.

What Does Diversification Mean in Investing?

Diversification is a strategy that aims to mitigate risk and maximize returns by allocating investment funds across different vehicles, industries, companies, and other categories.

What Is an Example of a Diversified Investment?

A diversified investment portfolio includes different asset classes such as stocks, bonds, and other securities. But that's not all. These vehicles are diversified by purchasing shares in different companies, asset classes, and industries. For instance, a diversified investor's portfolio may include stocks consisting of retail, transport, and consumer staple companies, as well as bonds—both corporate- and government-issued. Further diversification may include money market accounts and cash.

What Happens When You Diversify Your Investments?

When you diversify your investments, you reduce the amount of risk you're exposed to in order to maximize your returns. Although there are certain risks you can't avoid, such as systemic risks, you can hedge against unsystematic risks like business or financial risks.

The Bottom Line

Diversification can help an investor manage risk and reduce the volatility of an asset's price movements. Remember, however, that no matter how diversified your portfolio is, risk can never be eliminated completely.

You can reduce the risk associated with individual stocks, but general market risks affect nearly every stock and so it is also important to diversify among different asset classes. The key is to find a happy medium between risk and return. This ensures you can achieve your financial goals while still getting a good night's rest.

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