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The Importance of Diversification in Investing
Diversification is one of the most important concepts any beginning investor needs to understand. For all the tools and techniques available to the trader, diversification is still the single best strategy for optimizing risk.
In this post, we’ll break down what diversification is, the benefits of this approach, how this concept works in reality, and some of the limitations of this strategy.
What Is Diversification?
Diversification is the process of spreading your investments across various investment types, asset classes, sectors, industries, and regions. The goal is to minimize risk and optimize gains.
Specifically, you want uncorrelated investments so that if one investment tanks, it doesn’t drag down the rest of the portfolio.
In other words, diversification is not putting all your eggs in one basket. But you also don’t want a hundred baskets. The diversification process is about finding the right balance between the two extremes.
This process isn’t about maximizing gains. It’s about optimizing gains in the context of minimizing risk. If risk is like an air conditioner, then diversification is the thermostat to adjust that risk, setting it higher or lower based on your individual tolerance and goals.
Before we get too deep into diversification, you need to understand the basic idea of risk. Risk is inherent in any investment because, without risk, there would be no reward.
In a sense, you’re getting paid to take risks. Generally, the amount you get correlates to the risk you’re willing to take.
Investment risk comes in two forms:
- Systematic risk, or market risk, affects the entire market equally and cannot be eliminated. Inflation, exchange rates, interest rates, political instability, natural disasters, war, and more can all affect the market. That’s just the price of doing business.
- Diversifiable risk, or unsystematic risk, is linked to specific stocks, industries, asset classes, etc. The more concentrated your investments are in a single type, the more exposed you are to diversifiable risk.
Since you can’t do anything about systematic risk, the diversifiable risk is where you’ll put all our focus. That is what we’ll look at next.
Diversification Options Across Different Investment Vehicles
Investing in mutual funds or exchange-traded funds (ETFs) is the easiest way to diversify your portfolio. By design, these funds are already diversified, exposing you to a wide range of stocks, sectors, and other asset types.
If you’re intent on diversifying your portfolio yourself, be sure your portfolio covers the following areas:
Even if you’re focusing on a single sector, it makes sense to at least own several companies within that sector to protect against any number of catastrophes that can befall a single company.
Most of the benefits of diversification are here. Investing in uncorrelated sectors (e.g., financials and health care) can protect you against sector-wide downturns.
Different Asset Classes
Beyond just owning stocks, investors can add a wide variety of asset types to their portfolios to protect against market risk. These assets include bonds, real estate, precious metals, cryptocurrency, etc.
To protect against regional events and geopolitics, it makes sense to invest in various locations, both within your home country and abroad. Global markets are popular options, and many have ETFs too.
Benefits of Diversification
Here are some of the specific benefits of the diversification process:
- Risk management: This is the primary purpose of diversification. If one investment type gets hit hard, your other investments can help cushion the blow.
- Increase risk-adjusted returns. If your portfolio is adequately diversified, you should make more money at any risk level. Even a few percentage points over the long term can significantly impact the results.
- No single point of failure. If all your money is in one investment and fails, the consequences could be catastrophic for your long-term goals and financial future.
- Create opportunities. With a more diverse portfolio, you’re exposed to a wider variety of investments. The more exposure you have, the more likely that one of them could take off. While this isn’t the strategy’s primary purpose, it’s a powerful side benefit.
- More fun. It’s just more fun to be involved in an array of investments. It makes more market news relevant and makes the entire process more engaging.
Limitations of Diversification
While diversification is an essential aspect of portfolio design, it has some limitations:
- It cannot eliminate all risks. It is only possible to make returns in the market by taking on some risk. While diversification helps set risk below your tolerance threshold, it can’t erase it entirely.
- Complicated to set up and manage. Diversifying a portfolio can be daunting if you don’t know what you’re doing. The more you own, the harder it is to manage. There are also tax complications as you deal with more transactions, dividends, etc.
- Potential for lower returns: Diversification may limit your overall gains as your investment spreads across various assets. Remember, diversification should optimize risk-adjusted returns, not the highest overall returns.
- Expensive. Buying and managing a portfolio with 30+ stocks can rack up transaction fees. Investing in ETFs or mutual funds can avoid this to some degree. However, you may end up replacing transaction fees with management fees.
Example of Diversification
To understand diversification more clearly, let’s look at a concrete scenario.
All-in-One Basket Example
Let’s say all your money is on semiconductors, many of which are made in Taiwan. Then an earthquake hits Taiwan and wrecks the factories. Boom, our portfolio is down 50% in a day.
Different Companies in the Same Sector Help
You could spread your investment into other tech stocks to avoid this scenario. That will help – to a point. The problem is that many tech supply chains depend on semiconductors made in Taiwan. So, while these stocks may not be down 50%, they’ll still have a bad day.
Unconnected Sectors Offer More Protection
To further improve your position, you want to make sure your portfolio includes uncorrelated stocks, meaning sectors or asset types that are entirely unrelated. In our example, investing in healthcare would help insulate your portfolio from the effects of a tech sector crash.
Entirely Different Markets Give You a Buffer
To improve your position even more, you want investments separate from the stock market, protecting you from a market crash. Owning precious metals, real estate, and other asset types can safeguard you from market turbulence. Some of these things are inversely correlated to the market, so as the market drops, you can make gains.
Limits Still Exist
However, there are limits to the value of continued diversification. It’s possible to have a portfolio that is so diverse that it limits your ability to make gains. While opinions vary, many experts suggest owning between 15 and 30 stocks can diversify a stock portfolio optimally.
Our Opinion on Diversified Investments
We highly recommend a diversified portfolio for any long-term investor. The problem is this is a complex process to try and do independently. Like any individual stock pick, achieving optimal portfolio diversification takes a lot of time and experience to get right.
Investing in ETFs, mutual funds, or target date funds is the more straightforward way to take advantage of diversification. These investments give you all the diversification you need in a single buy – very little research and analysis are required.
Over time, as you learn more about the market and how it works, you can start researching and investing in individual stocks to try and squeeze more gains out of your portfolio.
Diversification Gives You Balance
Understanding this process is a key step toward building a sound investment strategy. And while It can be a powerful tool to manage risk and potentially increase returns over the long run, it isn’t a guarantee against losses.
How exposed are you if a stock or sector suddenly collapses? Do you have time to recover? Always analyze your portfolio in the context of your own goals and strategies.
If you already have a portfolio and want to see how well diversified it is, StockMarketEye has several built-in reports to show you just that. Try our no-risk, 14-day trial so you can input all your various investments and see precisely where they are allocated.