Diversification in Investing: What It Is and Why It Matters

Diversification in investing is a strategy that involves spreading your investments across different asset classes, industries, and regions to reduce risk. By diversifying, the poor performance of one asset may be countered by the more robust performance of another, creating a more balanced return. The core idea behind diversification is to hold a variety of investments that are not closely correlated, reducing overall portfolio risk.

Investment professionals agree that diversification doesn’t wholly prevent losses but is crucial for long-term financial goals and risk management. This article will explore why diversification is essential and how to apply it to your investment portfolio.

Key Takeaways

• Diversification reduces risk by investing across different financial instruments, industries, and other categories.
• Unsystematic risk can be reduced through diversification, but systematic or market risk is unavoidable.
• Investors may choose individual assets or index funds, which contain a variety of companies and holdings.
• Balancing a diversified portfolio can be complicated and lead to lower returns due to mitigated risk.
• A well-diversified portfolio can offer better opportunities, enjoyment in researching new assets, and higher risk-adjusted returns.

Understanding Diversification in Investing

Let’s imagine your portfolio is solely comprised of airline stocks. If there’s bad news in the airline industry—like a prolonged pilots’ strike—it could severely impact the value of your investments. However, if your portfolio also included railroad stocks, only part of your portfolio would suffer, and the other part could even benefit as more people turn to railways. This is the core concept of diversification: balancing your investments across different assets to mitigate potential losses.

Instead of focusing on maximizing returns by picking the most profitable companies, diversification takes a more defensive approach, aiming to protect against downturns. This strategy is endorsed by financial authorities like the U.S. Securities and Exchange Commission (SEC).

Diversifying Across Sectors and Industries

An example of diversification is balancing your investments within a specific sector, such as transportation, by holding airline and railway positions. However, this still exposes you to sector-wide risks. If travel as a whole declines, both industries may be affected. To further diversify, you should consider other sectors that might benefit from decreased travel, such as technology companies offering streaming services.

Diversifying Across Companies

Risk isn’t limited to industries; it can be specific to individual companies. Imagine a company led by an iconic leader—if that leader leaves, it could hurt the company. To reduce this company-specific risk, you could invest entirely in other companies within the same industry or even in different sectors.

Diversifying Across Asset Classes

Diversification extends beyond stocks. Different asset classes, such as bonds, real estate, or commodities, behave differently under various market conditions. For example, when the Federal Reserve raises interest rates, stocks may perform well, but bond prices often decline. You can reduce your overall risk by spreading investments across different asset classes.

Modern portfolio theory also suggests including alternative assets like cryptocurrencies or precious metals, each with unique success factors. A simple way to diversify is through broad market indexes, such as the S&P 500, which includes companies from different sectors, sizes, and strategies.

Diversifying Across Borders

Geopolitical and international risks can affect markets globally, but different countries have different risk factors and opportunities. For example, changes in U.S. corporate tax policy could negatively impact U.S. companies, but international companies may be unaffected. Investing in companies across various countries can protect your portfolio from localized risk events.

Diversifying Across Time Frames

Another layer of diversification involves considering the time frame of investments. Long-term bonds usually offer higher returns due to higher risks. In comparison, short-term investments are more liquid but yield lower returns. For example, an airline manufacturer may take years to complete a business cycle. At the same time, a retail company might turn inventory daily. Real estate investments, too, may be tied to long-term leases. In general, longer-term assets carry more risk but offer higher returns.

How Many Stocks Should You Hold?

You need to hold no magic number of stocks to avoid losses. Still, experts suggest that having 15 to 30 stocks across various industries can offer optimal diversification. The Financial Industry Regulatory Authority (FINRA) recommends consulting with an investment professional to determine the ideal stocks based on your individual goals and circumstances.

Index funds are a practical solution for investors who need help to afford to buy shares in 30 different companies. These funds provide exposure to a wide array of companies, reducing risk while keeping transaction fees low.

Different Types of Risk

Investors face two primary types of risk:

• Systematic Risk (Market Risk): This risk affects the entire market, such as changes in interest rates, inflation, or political instability. Systematic risk cannot be eliminated through diversification.
• Unsystematic Risk (Diversifiable Risk): This is specific to a company, industry, or country. Factors such as a company’s leadership or financial health fall under this category. Unsystematic risk can be mitigated by holding a diversified portfolio.

While systematic risk affects all investments to some extent, unsystematic risk is unique to specific investments and can be reduced through diversification.

Benefits of Diversification

Diversification helps protect your portfolio from significant losses, especially for investors nearing retirement who must preserve capital. Additionally, diversification can increase risk-adjusted returns, meaning you achieve better returns than the risk taken. Investing in various sectors opens the door to new opportunities, which can be more enjoyable as you learn about different industries.

Potential Problems with Diversification

While diversification is often recommended, it has its downsides. Managing a diverse portfolio can be cumbersome, especially with many holdings. Modern tools can help with portfolio tracking, but maintaining detailed records can still be challenging, especially for tax purposes.

Diversification can also be costly. Though recent trends toward commission-free trading have reduced fees, buying and selling different assets can still incur expenses. Moreover, some complex financial products could be more challenging for beginner investors.

Finally, some risks, like those from global events such as the COVID-19 pandemic, cannot be diversified away. In these cases, all asset classes may be negatively impacted.

Diversification Can Potentially Lower Returns

While diversification reduces risk, it may also lower your portfolio’s potential returns. By spreading investments across different assets, you might miss out on high returns from a single stock or sector that outperforms the market.

For example, Andrew Carnegie famously advised: “Keep all your eggs in one basket but watch that basket closely,” suggesting that focusing on a single investment allows for more excellent monitoring and potential returns. Warren Buffett has echoed similar sentiments, although this strategy carries more risk.

The key is to balance diversification and return maximization based on your risk tolerance and financial goals.

Why Is Diversification Important?

Diversification is crucial because it helps you manage risk, reducing the chance of significant losses. By spreading investments across various assets, you’re less likely to be affected by a single adverse event. This capital preservation is especially vital for retirees or those approaching retirement who rely on their investments for income.

What Does Diversification Mean in Investing?

Diversification involves spreading your investments across different vehicles, industries, and regions to mitigate risk and enhance returns.

What Is an Example of a Diversified Investment?

A diversified portfolio might include stocks, bonds, and other securities from different companies and industries. For example, it could contain shares of retail, transport, and consumer staple companies, along with corporate and government bonds.

What Happens When You Diversify Your Investments?

By diversifying your investments, you reduce unsystematic risk. While systematic risks cannot be avoided, diversification helps shield you from risks tied to specific companies or sectors.

The Bottom Line

Diversification is an essential strategy for managing risk and reducing volatility. While it can’t eliminate all risks, it helps mitigate the impact of poor performance in individual investments. A balanced approach to diversification will help you achieve your financial goals while protecting your portfolio from unnecessary risks.