Diversification is one of the most important investing principles.
I’d say it’s in the top 3 (it’s that important).
Creating a portfolio of diversified investments is 100% needed to achieve long term growth. Without diversification, you are at the mercy of market swings. It could swing up and make you a lot of money, or swing down and kill your retirement funds.
Diversification in investing is important because it helps you manage the unpredictable markets.
Just What Is Diversification?
It’s quite straight forward to define diversification.
Diversification Definition: Diversification is an investment strategy where the investor invests in a variety of investments to mitigate market risk.
In normal people speaking language, diversifying your investments means NOT putting all your eggs in one basket. If you’re not putting all your eggs in one basket, then by definition, you are putting your eggs in many baskets. This is a GOOD thing and a “must do” for strong and steady investment growth.
So why don’t you want to put all your eggs in one basket? Why wouldn’t you want to invest in all the Apple (AAPL) stocks you can afford, and nothing else? I mean, Apple has a rich history of success, growth, innovation, and record profits, and don’t look like they’re slowing down any time soon… It’s got to be a fool proof stock, right?
No! Here’s why…
Every stock has risk. Even the most proven stocks with the best track record of growth and dividend payments have risk. What kind of risk? Risk from losing value. It’s call “investment risk”.
The main reason why you want to diversify your investment portfolio is because you need to manage this investment risk. For example, The price of Apple stocks can fall. Why? Because Apple can go bankrupt. Apple can be taken over by (gasp) Samsung. And maybe cell phones and Apps won’t be popular one day. Basically, no company is immune to losing stock value, and therefore no company can guarantee growth of your investment portfolio.
I’ve used stocks as my example of an investment that has risk, but virtually all other types of investments have risk, too. A couple other popular types of investments are bonds and real estate. I’ll get into creating a diversified portfolio of investments later on where you’ll get to see what a diversified investment portfolio looks like.
So you know now that you want to diversify investments by choosing many types of investments to create your diversified portfolio. Before you can even diversify investments though, you’ll want to know WHAT types of things you can diversify against. In other words, what types of risk you can manage.
Types Of Diversification Risk
There are two types of diversification risk. Diversifiable risk and Un-diversifiable risk.
- Diversifiable Risk Definition: Any risk you can reduce via diversification. These are things you have SOME control over. And when I say “control”, I mean controlling the risk it has. In the case of stocks, a technology company can lose value because of things like strikes, product recalls, fierce competition, bad management, and poor innovation. You obviously can’t decide what products a company should sell or who it hires as CEO, but you have the ability to reduce these potential company risks by investing in different technology companies or companies completely unrelated to technology. So if one of your stock plummets, the others are (hopefully) holding steady or growing, minimizing the true loss of the plummeting stock.
- Undiversifiable Risk Definition: Any risk you cannot reduce via diversification. Some investments have risk that you can’t really do much about. This type of risk affects an entire market, rather than an individual company or sector (like technology) – which is why you can’t truly manage its risk. For example, wars, interest rate changes, and inflation are things that can directly affect the value of an investment – but these are things you will never be able to reduce the risk of with diversification. A great example of undiversifiable risk is the stock market crash in 2008. Virtually every stock lost value, and there was no way a diversified portfolio would have saved you from this catastrophic event.
Your Diversification Strategy
To create your diversified portfolio, you will want to do 2 very important things:
- Diversify Across Investments: You will want to include different types of investments in your portfolio. Stocks and bonds are the popular choice for many people, however there are other types of investments you can use to create a diversified portfolio. Real estate Investment Trusts (REITS), cash, money market funds, Mutual Funds, and physical gold are other examples.
- Diversify Within Investments: There are several ways to diversify within investments. Sticking with stocks as an example, you can purchase stocks in different sectors. For example, you can buy technology stocks, health stocks, or natural resource stocks. You can also buy different styles of stock, like small cap, medium cap, and large cap stocks.
So how does diversifying across investments and diversifying within investments help mitigate risk?
I think the best way to explain this is to give an example. Let’s say you invested all your money in various health related stocks (this is a bad idea btw). And let’s say one day it’s announced that Dr. Joe invented a magic pill that will get rid of cancer for good. What would you predict would happen to some (maybe all) of your health stocks? It’s likely that they will fall in price because if less people need health care, there will be less demand for health related services and businesses. And because your entire portfolio is invested in health stocks, you’re investments could potentially fall dramatically.
Now, if you had a couple health stocks along with 20 other stocks in other industries completely unrelated to health, and a cancer magic pill was announced, you may still see SOME loss in value of your overall portfolio. But this loss will be much much less than had you invested entirely in health stocks.
A smart way to counter balance falling stock prices is to buy bonds. This isn’t always the case, but typically, when stocks are doing well, bonds don’t do as well. And when bonds do well, stocks don’t do as well. So you may lose at one end, but you’ll likely be gaining at the other. In the end, it helps manage the risk of being devastated by large decreases in values of a type of investment.
Investment Diversification Types
Stock diversification is essential to long term growth. Stocks prices can drop suddenly and snowball down for months or longer. You could lose half your investment or more in just weeks. Creating a diversified stock portfolio isn’t a question, it’s a requirement! How many stocks do you need to have a “diversified stock portfolio?” Experts say around 20. This isn’t a hard rule. You could have 10, or 35. How many you buy depends on many things, including your investing expertise and willingness to take on risk.
There are different types of bonds and they all come with different levels of risk. For example, Government bonds are the safest types of bonds. They are backed by the U.S. Treasury. While technically it’s possibly for the U.S. Government to go bankrupt, I doubt it’s ever going to happen. A corporate bond is issues by a corporation, and holds much more risk. This is called credit risk, and it’s the risk a company may fail or go bankrupt. You may lose your entire bond investment or a portion of it.
Mutual Fund Diversification
A mutual fund is a portfolio of a variety of investments. For example, a “balanced mutual fund” typically contains a mixture of stocks and bonds. Mutual funds are popular because they already have diversification built into them. When you buy a company stock, you are investing in one company. When you buy a mutual fund, you could be purchasing a portfolio that has stocks from many different companies, and maybe bonds too – just depends on the type of mutual fund. Mixing mutual funds with your stocks and bonds is just another way to diversify.
When people think of diversifying investments, they almost always think about securities (stocks), bonds, mutual funds, and real estate. But you can diversify further than that. Basically anything that is considered an asset can help you diversify. For example, you can buy physical gold, rental properties, rare artwork, or buy businesses.
Example Of Diversified Investments
Diversification and asset allocation go hand in hand, like butter on bread. Asset allocation is simply deciding what investments you want, and how much percentage of each.
- a portfolio that is 80% stocks and 20% bonds is a pretty aggressive portfolio
- a portfolio that is 20% stocks and 80% bonds is a conservative portfolio
Regardless of the percentage of stocks and bonds, you want to pick very different stocks and bonds to make up your portfolio.
Can You Over-diversify Your Portfolio?
You absolutely can over-diversify. You want the benefit of growth while maintaining a reasonable level of risk. If you have 100 stocks and 50 bonds, you probably have too much. With this much of a mix, your investments can’t really make an impact. Any stocks that perform well will likely be drowned out by the dozens of other stocks that aren’t moving up or are stagnated.
What’s the right amount of diversification then? This is a hard question to answer, and it will be different for everybody since every investor has their own preferences and style. But I’d say 20 stocks is a good number, and maybe 5 bonds.
The benefits of diversification are far reaching. Diversification in investing is important because it helps you manage risk.
By spreading your investment risk throughout several different types of investments (stocks, bonds, mutual funds, etc), and choosing investments from different sectors (technology, health care, travel, etc), you are preventing yourself from incurring big losses if a certain industry or type of investment were to fail.
Diversification is an investment strategy to mitigate risk. All investments comes with risk. Investments like stocks have a lot more risk than an investment like treasury bonds. You’ll need to create your portfolio of investments based on how much risk you’re willing to take on.
The only time you’d never want to diversify is if you know for sure what stocks will increase in price. Because, when you know who the winners are, you better damn put all your eggs on those baskets! But, not even Warren Buffer is that smart, so you will need to have a diversification strategy.