- Diversification is a fundamental principle of investing because it helps you grow your portfolio and protect it at the same time.
- Asset Allocation Funds and Index Funds are some of the more commonly used ways of diversifying a typical portfolio
- Putting money into investments and asset classes with little correlation improves diversification
- Diversification isn’t foolproof — every investment comes with risk and no strategy will eliminate that
Of all the main principles of investing, few are as fundamental as diversification. It is an essential way to not only create reliable returns but also protect you from losing your shirt.
No investing strategy is foolproof. But it is so powerful that — when employed smartly — proper diversification can almost ensure that you will not get wiped out entirely.
This is why it sits as the cornerstone of so many investment profiles.
But what is it, why does it matter, and what are some common strategies?
What is diversification?
In the most basic terms, diversification is so simple that you probably learned it from your grandmother: “Don’t put all your eggs in one basket.”
Diversification is all about spreading out your money and — in the process — spreading out and lowering your risk. It is based upon the notion that any one investment or venture could fail. Even “can’t miss” opportunities crash and burn. No matter how safe you think something is, if you invest your entire life savings, you could potentially lose it all.
On the other hand, if you divide up your overall total — by, say, putting 10% of your money into 10 different investments of varying risk — it’s less likely that they will all fail.
Diversifying your investment portfolio isn’t magic, however. You take on some risk in every investment. That is always important to remember. Still, the odds of losing everything are reduced significantly when you diversify well.
What are the most common diversification strategies?
The traditional business school example of diversification is splitting an investment between stocks and bonds. Stocks are more volatile and can lead to larger returns — or faster losses. Bonds are more stable — but typically have much less financial upside.
If you divide your money between both categories, you can get the best of both worlds. You will still have big potential windfalls from a bull market for stocks while protecting your money and enjoying reliable, if small, returns from boring, low-risk bonds. Many people use asset allocation funds to invest in both at the same time.
In the stock market, there are also index funds. Rather than buying an individual company stock, you may put your money into the S&P 500 — a collection of all the largest companies on the New York Stock Exchange.
This is, in theory, safer than simply buying the stock of one company. Even blue chip firms like Coca-Cola, Walmart, or Google could see their stock price drop fast. This goes even more so for younger startups soon after their IPO or firms operating in volatile markets.
On the other hand, an index fund (like the S&P 500, FTSE 100, Fidelity 500, or many others) will also go up and down. But the swings are usually less drastic, and over the long term, the investment will likely be more stable than individual stocks.
A scandal or ruinous quarter at a single company won’t hurt your investment as much if it is only a small part of your overall portfolio. But if you only have that one stock, you can suffer a major loss.
What is diversification done smart?
There is one key to remember here: Not all diversification is created equal. Smart diversification still requires putting all of your money — or at least most of your money — into “solid” investments. An index fund, among other options, usually qualifies.
But if you make 10 very risky moves, diversification may not be able to save you. Nothing will make investing in 10 different rolls of a roulette wheel safe. There’s a reason they call it gambling.
Stated another way, putting your 10 eggs into 10 different baskets only helps when they are good baskets. It might do you no good at all if all those baskets are sitting outside right next to a fox den.
Furthermore, some risk just cannot be effectively lowered through diversification. If a major global event happens, many of your investments are probably in trouble. In a less dramatic example, no amount of diversification will reduce the risk of inflation — something that affects the value of all money.
How do you measure diversification in your portfolio?
Big investment banks and hedge funds use advanced algorithms and complex computing methods to keep tabs on every aspect of their portfolio. They crunch data, analyze changes in microseconds, and employ formulas to manage their risk and exposure to various markets. These days, the tech is overwhelmingly advanced.
There are some tools for individuals to use. But measuring diversification isn’t usually such an exact science for the average personal investor. For most people, it is about using common sense. The basic question is asking yourself where your money is. Which baskets, and how many baskets, are you in?
You can take this as far as you want or keep it pretty simple.
Think about someone who invests in real estate. It might not be ideal to buy five houses on the same block. One massive fire or weather-related event could potentially take them all out.
By contrast, if you buy five different properties in five different towns, you are protected — at least from these specific risks. But what if a statewide economic crisis kills property values? So maybe you decide to buy one house in your hometown, one in New York, one in Texas, and on and on. Sure, a nationwide or global crisis still leaves you in trouble. But you are no longer exposed to a fire or the economic fallout in any single state.
That’s diversification — on some level. Still, you’re only invested in real estate. If that market falls apart, you could be in trouble. So maybe look for different asset classes that have less “correlation.”
You sell one property and put that money into stocks. Then you sell another and put that money into Treasury bonds. Then you sell a third and invest in a tech startup. Finally, you sell another to invest in gold or oil futures.
Now you’re invested in five different asset classes, and they have much less correlation. You have now greatly increased your diversification — by any measure.
Diversification can be taken as far as you want. If you put all your money into one or two areas, you are still exposed to a lot of risk. If you try to lower risk too much and spread things across a thousand stable areas, you might miss out on a lot of growth.
As usual, balance and Goldilocks principles — not too much, not too little — usually make the most sense for most people. Don’t ignore diversification, but don’t make all decisions with an obsession to stay perfectly diversified.
Diversification is usually a core component of any balanced, healthy investment portfolio.
If you understand how it works and put it to use, your investment strategy can only become more sound.