Many investors would agree that diversification plays a crucial role in the long term success of most investment portfolios. When it comes to investing, you will often hear of the importance of diversification but what exactly is diversification and why is it so important?
What Is Diversification?
Within the investing world, diversification defines the process of allocating investment capital into multiple investments across different asset classes, with the aim to reduce the unsystematic risk of suffering severe losses in case of poor investment performance.
In simpler terms, you want to spread out your risk amongst several assets that don’t correlate with each other as much as possible in order to have a lower chance to encounter severe losses. Just like the saying “Don’t put all your eggs in one basket”.
You may probably already know that nearly all investments you make, come with a certain amount of risk. For instance, when you invest in stocks, you will automatically encounter several types of risk, and one of them is the probability that the company you invested in may go bankrupt at some point in time.
One way to encounter this type of risk is to allocate your money into several companies instead of one because the chance that multiple companies go bankrupt at the same time is significantly lower than the probability for one single business to fail.
You would now be diversified across multiple companies. However, this way of diversification doesn’t necessarily guarantee a safe investment return. In fact, diversification in general, will never assure that. What it can do at most is to minimize your investment risks as much as possible.
How to Effectively Diversify
Just spreading risk across multiple companies isn’t the most effective way to diversify but it is considered as some way of diversification. It does reduce some risk but certainly not nearly as much as diversification can potentially provide.
Spread Your Wealth
When it comes to investing in stocks, it is always important to invest in several companies instead of one single business. Therefore, spreading your risk among companies that are operating within different industries that are not correlated to each other can already be considered as a way of diversification. One way to achieve this is to invest in the whole market through index funds or ETFs.
Nowadays, the most well-known stock index is the S&P 500. It consists of 500 major companies trading at stock exchanges within the United States. The S&P 500 is also used to measure the general performance of the stock market.
By investing in an index such as the S&P 500, you automatically spread your wealth across the biggest and most successful companies trading at the stock market. Most people who just want to take part in the decent returns of the stock market can simply invest their money into a stock index like the S&P 500 since the approach of passive investing generally provides a more solid and safer way than to actively pick the right stocks.
Even great investors such as Warren Buffett recommend most investors to put their money into the S&P 500.
“Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund.”
That being said, stocks and equities in general, can definitely drop as a whole and you could still end up losing a great proportion of your investment portfolio, even if you were diversified across several different companies. This is because stocks are mostly correlated to each other and in times of market crashes such as the market crash of 2008, it is certain that nearly all companies are going to plunge even without a proper given reason.
A grouping of investments that acts with similar behavior towards economic activities is called an asset class. Most experts agree that investors should be invested in several asset classes. This is because when you as an investor are spread out to assets that don’t correlate to each other, the probability for your investment portfolio to suffer a severe loss is minimized to a great extent.
For instance, when a stock market crash occurs, and you were exclusively exposed to stocks and equities, your portfolio would definitely experience a big loss. However, if a considerable proportion of your portfolio would be in bonds, you would most likely not lose as much since bonds as an asset class tend to go up when stocks and equities fall. The increase in the value of your bonds would then offset your losses from the decline of your equities.
This is what diversification is all about. Mixing uncorrelated investments with the intention that as soon as one asset falls, the other rises.
Bonds usually tend to do well when the economy slows, while stocks tend to go up along economic growth. There is no positive correlation between these asset classes. Therefore, an investment portfolio that consists of a mixture of both would reduce the risk of potentially suffering a big loss for your investment portfolio. The only downside to diversification is that investors may have to accept a reduced return in order to be opposed to less risk. Simply because stocks tend to perform quite better than bonds in general.
That being said, the investment return is not necessarily the most important part of a good investment. The return should always be weighed against the risk of a potential loss. Therefore, it is essential to find the best suiting balance between the risk and reward of your portfolio.
Different Asset Classes
Apart from stocks and bonds, there are several more asset classes that can be chosen for diversification purposes. Here are some brief descriptions of common investment securities that you may want to consider investing in:
Domestic and international stocks. Many investors are likely going to prefer stocks of companies that are operating within their own country. Equities are probably going to be one of the most volatile and aggressive positions of most portfolios, while they may offer the best potential return. As already mentioned above, investors should not put their whole stock proportion on just one single company. Instead, it would be more beneficial to be invested in multiple businesses operating across different market sectors, or consider putting your money in a stock index such as the S&P 500.
Of course, American stocks are not necessarily the only place to invest in. Foreign stocks tend to perform with less to no correlation to U.S stocks since they operate within different economies. Additionally, they can provide better opportunities for the investor but are generally considered less safe by most people.
Bonds and other fixed income. More conservative investors that don’t want to deal with an increased amount of volatility in the short term may consider having a larger proportion of their portfolio in bonds. While there are several types of bonds coming with different levels of risk and return, most bonds provide a fixed interest and are a great way of adding diversification as a counterpart to stocks. However, please note that not all bonds are considered safe investments. There are types of bonds such as high-yield bonds that may even have more risk than some stocks.
Commodities. One of the most common commodities that many people invest in are precious metals such as gold or silver. Having a little exposure to gold can potentially furthermore offset losses in times of stock market crashes or economic uncertainties. Gold, for instance, can be used as a great hedge in such events, as it tends to spike up shortly in price when people are faced with bad economic events and they invest in gold as a reaction of fear.
Here is a simplified example of how a diversified portfolio may look like:
It is no surprise that diversification plays a huge role in the modern investing world. Proper diversification can be the main tool for adjusting the market risk of one’s investment portfolio. However, you should still note that even the best approach to diversification will not guarantee complete safety for your investments.