Diversification: What is is and why it is important

Diversification

In this post I will discuss diversification and its importance to your investment portfolio. You may have heard that a good investment portfolio is a diversified one. Diversification means to spread your money across different types of investments and asset classes. First of all by spreading out your investments to different sectors and industries you are reducing your risk. For example, if you were invested completely in airline stocks and there was a pandemic such as COVID-19 we are you would see a significant impact to your portfolio.

Types of risk

As investors we experience unsystematic risk when we are invested in a specific company or industry, sometimes called putting all our eggs in one basket. It is better to invest in various assets to alleviate risk exposure during certain market events. Additionally, you may want to consider investing in different size companies. This type of variety can be a good strategy since sometimes smaller startups have more room for growth. Similarly systematic risk must be accepted by all investors and all classes of assets are susceptible to systematic risk. Diversification can not prevent this type of risk since its causes may include things like inflation and interest rates.

Using our airline stock example and we wanted to diversify our portfolio, cruise line stocks would not be a good choice because they are both related to the travel industry. Hence if the travel industry were to suffer our entire portfolio would be negatively impacted. However, a better choice might be to invest a portion of your funds into real estate, pharmaceuticals, or agriculture. Diversification should be done not only across different  industries but across different asset classes. Some investors also look at geography to diversify. Investing in other countries or international stocks carries a higher level of risk which can be impacted by different events such as, political turmoil, war, and natural disasters.

“Diversification will not guarantee better returns or fewer losses.”

Diversify beyond stocks

A different class of assets beyond stocks could be bonds or real estate. All of these different classes will react differently to world events and market fluctuations. The less connected your investments are the better you can mitigate risk. An investment into an index fund is a form of diversification as this type of fund buys many different companies inside of one fund. An S&P 500 index fund buys into all 500 stocks that make up the S&P 500. If you invest into one of these funds your investment does what the market does, when the market goes up so does the value of your investment. Those who are sold on the idea that stocks and bonds are the only way to go may want to consider life cycle funds or Target Date Funds. These are portfolios that adjust over time to shift from more aggressive (usually stocks) to safer (usually bonds) the closer the fund gets to maturity.

The downside of diversification

If there is a downside to diversification, not all assets and investments are created equal. Some will carry more fees and more importantly they will experience different returns. Stocks and Bonds do not react the same way to market fluctuations and negative effects on one can be offset by positive results with the other. Additionally managing and tracking several different asset classes can be difficult and confusing.

There is no autopilot

More importantly portfolios need to be monitored and adjusted over time. For example a good balance for you in your 20’s is probably not going to be the right mix in your 40’s or your 60’s. Some experts recommend re-balancing your portfolio annually or possibly even quarterly. Keep in mind if you are paying a professional they should be able to advise you as to when a re-balance is best for you. Be cautioned that buying and selling different assets may rack up additional fees. Management fees can reduce your returns since these fees add up and can have a significant impact over time.

The bottom line

To sum it up diversification helps us mitigate risk and manage market volatility. Remember no matter how diversified your investment portfolio is there will always be some level of risk involved. Index funds can be less risky than buying individual stocks. Investing in other asset classes will provide even more protection. Every investor is unique and will have different goals, risk tolerance, and time horizons. It is recommended to speak with a qualified investment professional prior to making any investments. Take time to educate yourself and if a professional recommends something you do not understand, let them know and do not move forward until you understand everything.