‘Don’t put all your eggs in one basket’ or ‘don’t trust all your goods to one ship’. Love ‘em or loathe them, these common phrases perfectly illustrate what we mean when we talk about investing diversification.
Financially speaking, stock portfolio diversification is a strategy where you invest in a variety of assets, regions, and industries to minimize risk.
Why is diversification so important?
Imagine you have all of your investments in a single technology stock. Suddenly, there’s a tech apocalypse (perhaps a little far fetched… or is it?!), which somehow doesn’t bring Wall Street to a standstill, and your stock loses 50% of its value. You’ve just lost an eye-watering 50% of your portfolio!
But, if that tech stock only makes up 3% of your portfolio, the 50% drop-off will be compensated by the other 97% of your holdings. So when you diversify, you are making sure that your investments are not subject to the exact same risks.
If diversification is supposed to iron out the losses in your stock portfolio when markets fall, it can also mean rewards when markets rise.
How risk works in investments
Before you come up with a diversification strategy, it is important that you understand how risk is generated and how it behaves.
There are two types of risk when investing in stocks:
- Systematic Risk: This affects an entire market, not just a particular stock, company, or industry. It is caused by broad economy-wide shocks such as a change in central bank policy rate, change in taxes, war, etc. Also known as “market risk” or “undiversifiable risk”, it is not possible to get rid of through diversification.
- Unique Risk: Also known as “unsystematic risk”, it is focused specifically in one company or industry. It appears from company specific factors such as loss of a major customer, a legal battle, any major regulatory action, etc. This type of company-specific risk can be ironed out through a correct diversification strategy.
Diversifying like a pro
The deal with diversification is that it only works if done well. That means investing in different assets (stocks, ETFs, bonds, index funds, mutual funds, etc.), industries and regions. In other words, securities in a portfolio should not ‘move together’ or have a mutual connection.
Let’s imagine that you invest all your money in the stocks of six different banks. In this case, it’s fair to assume that what affects one bank stock will probably affect the stocks of the other five banks in your portfolio.
But if you invest in different industries - let’s say you purchased one bank stock, one grocery stock, and a healthcare stock - what affects one doesn’t necessarily affect the other because each sector is different.
Consider different assets
Investing in stocks from different industries is a good way to build a diversified portfolio. But if you want to improve your diversification strategy, you can opt for investing in both stocks and bonds (both assets, but different).
Historically, the stock and bond markets are ‘negatively correlated’. That means when the stock market is up, the bond market is usually down and vice versa. This is the reason why, when creating a portfolio, conservative investors may rather have a mix of 80% bonds and 20% stocks, while aggressive investors choose a 20% bonds and 80% stocks portfolio.
An easy way to build a portfolio that includes stocks and bonds with a correct diversification strategy is to invest in mutual funds. A mutual fund is an investment method in which many investors make together a pool of money to be invested in different securities like stocks, bonds and other types of assets.
These portfolios are handled by professional money managers, who select a well diversified combination of assets to produce a good return with the least risk possible. No wonder why mutual funds are sometimes referred to as “balanced portfolios”.
Quick tip: If you want to have even more diversification in your portfolio, you may want to consider alternative investments such as real estate, foreign stocks, or even cryptocurrency. The point with these is to keep investing in other fields that do not necessarily move in the same way as financial markets.
Is there something like ‘too much diversification’?
Too much of a good thing is a bad thing. That’s a very appropriate saying when we talk about investment diversification.
Building a diversified stock portfolio still needs to be done by accomplishing the basic rule of investing: make all your decisions based on logic and correct analysis.
Therefore, what you need to keep in mind is that it is very possible to have an over-diversified portfolio, which in the long term will end up having a negative effect on your returns.
You don’t have to juggle thousands of different investments to have more profit. Most experts agree that 25-30 stocks is enough to diversify a stock portfolio in a cost-effective way. Having more stocks than that will cause that every investment loses its impact, causing more harm than good.
Diversification is a strategy that every investor should know about. It helps you get higher returns in the long-run, assuming less risk.
Although, there is no such thing as a diversification model that you need to follow to achieve success. It all depends on your personal risk tolerance, resources and financial goals.
To come up with a good diversification strategy you can start by figuring the mix of stocks, bonds and other assets that meets your goals. After that, consider alternative investments to complete your mix. Here, your investing experience will be the key to determine your portfolio as you will be understanding how every asset works.
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