Diversification is an important principle that prudent investors and advisors adhere to. It is best explained by the expression “don’t keep all of your eggs in one basket.” If XYZ stock is the basket you put all your eggs into and it goes haywire, all your eggs are gone. And that isn’t good.
Diversifying requires an investment among several other stocks and preferably from different industries. Now, if XYZ bites the dust, you still have unbroken eggs in your other baskets.
Diversification is a risk reduction strategy for many investors. While most associated with equity investments like stocks, it applies to fixed income securities as well.
Let’s say you open a Roth IRA. The first stock you buy is ABC Corporation which is a solar panel manufacturer. While there’s potential for reward if things go great with ABC, there’s also more investment risk.
If ABC doesn’t execute and begins losing customers, the value of your ABC stock will go down with it. Having all your investment in a single asset puts you at higher risk of loss.
To mitigate risk, you add XYZ stock which is a solar panel installer. Now you own two stocks so if one of the companies goes belly up, you still have equity ownership in the other.
While you have reduced your risk compared to the single investment in ABC, you are still exposed to market risk. For example, consider new regulations negatively impact the solar panel industry. It is likely both ABC and XYZ will experience a decline in value.
Now, let’s explore an investment in an index fund that mirrors the S&P 500. By any measure, this would be a diversified investment. The S&P 500 tracks the performance of 500 of the largest US publicly traded companies. Boom! That’s portfolio diversification.
Pros and Cons of Diversification
A diversification strategy will help manage portfolio risk by limiting loss from events that impact a specific company or industry. There is a much higher risk you’ll lose money when investing in one or just a small handful of companies.
On the other hand, with more risk comes the possibility of greater return. For example, let’s assume you invested $10,000 all in Apple stock in 1980. That investment would be over $14 million at the time of this writing.
Compare that with a $10,000 investment in the S&P 500 in 1980. After 42 years, this well diversified portfolio would have grown to roughly $300k. While a decent return, it pales in comparison to Apple’s stock performance.
How can I diversify my portfolio?
Whether investing in the stock market or fixed income securities, diversification is most typically achieved through mutual funds or exchange trade funds (ETFs).
Let’s say you want to invest in the technology sector. You could go out and do your own research. The you’d pick the stocks to include in the entire portfolio. Or you could put your money into a mutual fund.
The mutual fund manager is responsible for allocating capital based on their research and expertise. They will take your funds along with thousands of other investors and buy stock in hundreds of different companies.
Mutual funds aren’t the only way to improve diversification. Exchange traded funds or ETFs can spread risk among many different companies and often at a lower cost than a mutual fund.
While we most often associate diversification with stock market investing, it’s important for fixed income investments too.
If you are building a balanced portfolio and looking for treasury bonds or corporates, you will likely benefit by investing in a bond fund. An investment manager who knows the bond market can reduce overall portfolio risk by diversifying into a variety of different bond asset classes.
Just like stocks, there are exchange traded funds for bonds as well.
Understand your investment objectives, time horizon and tolerance for risk:
Think of this as your goal or purpose for investing. Are you trying to set aside funds for the down payment on a home, save for college, or build a fund for retirement? Is your goal to achieve significant growth of capital or to receive modest current income via dividends and interest?
This is the length of time you plan to hold the investment before you need it for its stated purpose or objective. Every investor will have a different time horizon. Is your retirement 5 or 25 years away? Will your kids be going to college in 2 years or 12 years?
The higher the expected returns of an investment, the greater the risk of loss. Your risk tolerance identifies how much risk you are willing to take. Would you lose sleep if your account value dropped by 5%? What if it dropped by 10%?
How would you react to seeing losses in your investment? Would you hit the panic button and sell everything, or would you hold on and wait for things to recover? Can you tolerate seeing any negative returns at all?
These are just basic examples but the answers to these questions will help you choose the investment plan that matches up with your risk tolerance.
Diversification is not the same as asset allocation:
What happens if the stock market crashes (think 2008-09 financial crisis) and you are 100% invested in an S&P 500 index fund? You guessed it. Your portfolio is going down with it. While the stock portfolio is diversified, it is concentrated in one asset class. That asset class is stocks.
To be fair, the same could be true for any asset class like bonds, real estate, or commodities. This is why diversification alone isn’t enough. You can be perfectly well diversified, but if you’re concentrated in one asset class, you’re likely taking on too much risk.
In general, there are five broad asset classes and include stocks (equities), bonds (fixed income), real estate, commodities, and cash (money market). There are sub-classes for each of these, but we won’t get into that here.
What is important is understanding that these classes have varying degrees of correlation to each other. As we discussed earlier, if your portfolio is 100% stocks, while you may be diversified, you are still exposed to only one asset class.
If things head south with that asset class, your diversified portfolio will be going down with it.
This is the process of identifying what asset classes to invest in and how much. In general, most investors will be considering how to allocate among stocks, bonds, and cash.
By adjusting the percentage exposure to these asset classes, it will be possible to create a portfolio with an appropriate level of risk.
SPECIAL NOTE: This table is for general explanation and education purposes only and should not be considered investment advice. You should not make decisions based on this table alone. Before any investment decisions are made, one must first carefully assess their investment objective, time horizon, and risk tolerance. Consult a financial professional for help with properly allocating investments among asset classes.
Diversification is critical to building a strong investment portfolio, but it isn’t enough. Without proper asset allocation, your diversified investment portfolio could seriously let you down.
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